The Japanese yen continued to rule weak against the dollar after last week’s solid GDP and jobs data out of the US, propelling stocks in the export-oriented country to solid gains.

Japan

The Nikkei 225 index put on 2.29% to close at 15,650.21 today. This was its best one-day gain in three months.

Year to date the index is up nearly 51%, and 2013 could be the best year for Japanese stocks since 1972.

Japanese stocks: Too much, too soon?

We looked for answers in a study of the outlook for Japanese stocks by analyst Kenji Abe included in the report “Pan-Asia Road Ahead: 2014 Outlook” of December 3, 2013 by Citi.

“Due to the consumption tax rate hike, the Japanese economy will likely slow but it should avoid a recession thanks to yen depreciation and fiscal stimulus. TOPIX EPS will likely hit a historical high in FY14, partly because of cost cuts being made by Japanese companies,” says Abe.

Catalysts for Japanese stocks

Strength in equities in 2013 will likely transmit to 2014 due to the impact of Abenomics, which will sustain weakness in the yen to improve the global competitiveness of Japanese exporters. Earnings will therefore improve and scale new highs. Regardless, valuations of Japanese equities still have room to move up.

Current valuations versus historical precedents

According to Abe, the CAPE ratio of the Japanese TOPIX index is still ruling lower than previous historical highs of about 20x, even considering the rise seen after October 2012. By that benchmark, valuations are not excessive.

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In the graph above, note that the current CAPE reading of 12.1X has just penetrated its long-term falling trend line, yet remains far below the previous peaks.

Citi’s sectors of choice

Citi prefer autos (including ancillary sectors such as auto parts, machinery and iron & steel) and financials in Japan. Autos stand to benefit from the export-competitiveness sparked by the weakened yen while valuations of financials have yet to catch up with the growth of earnings.

Citi’s stock picks

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