Japanese stocks lost $1.1 trillion in value in a record three-day rout in early August. For bullish investors, that provided a new reason to buy one of the hottest trades of 2024.

The stocks that have been hit hard are those that had previously risen the most, and their prices have been pulled down to more attractive levels. The valuation improvement activities aimed at improving the international appeal of Japanese stocks are still continuing, and the market, now worth $6.1 trillion, has removed some of the froth.

The Bank of Japan caught traders off guard last month by raising interest rates, but it later said it would not tighten too quickly to avoid further market turmoil. That helped curb the yen’s sudden rise, removing a key threat to the stock market rally.

In terms of major global catalysts, the latest U.S. labor market data helped ease concerns about whether the Federal Reserve can act quickly enough to avoid a potential recession. The world's major technology companies are moving forward with plans to invest billions of dollars in artificial intelligence infrastructure.

“We’re not facing a major economic or financial crisis,” said Tetsuro Ii, chief executive officer of Commons Asset Management Inc., adding that it may take only two or three months for the market to fully recover.

Investors now recognize that monetary policy in Japan and the United States has "entered a new phase," and they see this as a signal to exit crowded positions.

The benchmark Topix index has fallen 12% since the end of June. Stocks that outperformed earlier this year have suffered even greater losses. An MSCI Inc. index of Japanese semiconductor-related shares has fallen 25% in that time. Bank stocks, which had surged on expectations of higher Japanese interest rates, have fallen 16%.

“I wouldn’t say it’s a bubble, but the market is just a little overextended,” said Toru Yamamoto, chief strategist at Daiwa Asset Management Co. “When you need to reduce risk, the most inflated positions will be cut.”

Japan has become one of the favorite markets for global traders this year on expectations that inflation will return after more than two decades of price stagnation and hopes that Japanese companies will return more cash to shareholders at the urging of the Tokyo Stock Exchange. The recent decline has made stocks cheaper, potentially making them more attractive to overseas investors such as Warren Buffett, who has poured money into Japanese trading firms.

The Topix now trades at 13 times expected earnings, compared with 20 for the S&P 500. Japan’s chip index has fallen to 21 times from 35 earlier this year.

“Last month people felt the market had risen a bit too much, but after the sell-off, the market is back to where it should be,” said Masayuki Murata, general manager of balanced portfolios at Sumitomo Life Insurance Co. At current valuations, “you can say we are at a level to buy on dips.”

Derivatives markets remain positive for the Japanese market, with open interest in bullish Nikkei options growing faster than put options. As a result, the put/call ratio has retreated to its lowest level in about six and a half years, suggesting that bets on a market rebound are becoming popular.

Still, risks remain, particularly from a stronger yen as the Bank of Japan tightens further and the Federal Reserve eases. The yen’s slide to multi-decade lows had helped boost stocks because a weaker yen is seen as boosting Japanese exporters’ earnings overseas. Geopolitical tensions that took the shine off tech stocks last month are lingering, especially as the U.S. election approaches.

The Nikkei Volatility Index, Japan's version of the "fear index," closed at 45 on Friday. While that's down from last Monday's intra-day high of 85, it's still well above its long-term average of about 22.

For Ben Bennett, head of Asia investment strategy at Legal & General Investment Management Ltd., overcrowding has become a reason to avoid Japanese stocks. "The question is whether this overstretched positioning has been significantly reduced," he said. "I suspect it will take more volatility to bring this positioning back to neutral. Given the recent weakness, I think investors who are bullish on Japanese equities may even add to their positions if something is done."

The recent turmoil is not surprising to Arihiro Nagata, managing director of Sumitomo Mitsui Banking Corporation, given the various pressures on the market at its highs. "I think the market will correct as long as there is a trigger," he said. "It's hard to predict, but I think positions have become lighter and the market has become cheaper."

The article is forwarded from: Jinshi Data