A report released by Morgan Stanley on August 6, 2026, regarding Japanese stock strategy, explicitly states that the most severe momentum reversal in the history of the Japanese stock market has largely been cleared. The market's investment logic, capital preferences, and valuation system are undergoing a comprehensive restructuring.
Amidst multiple variables such as coordinated intervention between Japan and the US in the forex market, the normalization of the Bank of Japan's monetary policy, and the spillover benefits of the AI industry, structural opportunities in Japanese stocks continue to expand. However, tail risks from rising oil prices and long-term interest rates also warrant close attention. This text dissects the underlying logic, fundamental support, policy impacts, core risks, and subsequent allocation strategies for the current Japanese stock market cycle.
Market Review: Historical Momentum Reversal Ends, Clear Signals of a Market Turning Point
Since July 2026, the Japanese stock market has experienced an extreme momentum adjustment, the likes of which have not been seen in nearly three decades, marking the biggest turning point for the market this year. Data shows that the cumulative drawdown of this price momentum strategy reached 36%, with the 21-day trading return falling to the 0.2nd percentile level of the past 30 years. Volatility climbed to a historical high of the 0.3rd percentile since 1995, with the severity of the adjustment far exceeding classic drawdown cycles like the 2008 financial crisis and the 2016 market correction.
From a capital positioning perspective, this adjustment exhibited typical structural liquidation characteristics. The previous market core themes of AI and technology growth stocks were the hardest hit, with long portfolios suffering a 20% loss and short portfolios a 16% loss. Positions in core AI cyclical growth stocks with high beta and high price-to-book ratios were significantly reduced. As capital liquidated in a concentrated manner, market style rapidly rotated, shifting capital from pure thematic growth stocks to value stocks with low volatility and high certainty, significantly widening the dispersion of market returns.
The end of the adjustment can be confirmed from capital behavior, with clear signals of a market bottom. In the final stages of this cycle, several large institutions liquidated their listed stock portfolio holdings, a classic sign of the end of momentum strategy liquidation in history. With speculative capital exiting, the overly crowded positioning of core AI stocks has been significantly alleviated, laying a solid foundation for a short-term market rebound. However, it is important to clarify that this adjustment is not a simple corrective rebound but a fundamental shift in market rules. Core AI growth stocks are no longer the sole driver of market gains, the comprehensive thematic bull market is over, and the era of refined stock selection has officially begun. Looking at the sideways trading range of the Nikkei in the second half of 2026, the overall index volatility is narrowing, but structural trends are prominent, perfectly aligning with the market characteristics after a style shift.
Fundamental Evolution: Broad-Based Earnings Surge, AI Dividends Achieve Widespread Diffusion
Unlike the previous market logic driven by valuation expansion and thematic speculation, the core support for the Japanese stock market in 2026 comes from solid corporate earnings recovery. The breadth and resilience of earnings growth have far exceeded market expectations, providing a solid fundamental foundation for the style shift. As of August 5, 2026, among the TOPIX constituents with fiscal years ending in February or March, 601 companies have disclosed their first-quarter results, covering 70% of the market's total market capitalization, making the sample highly representative. The overall performance data is impressive, with significant year-on-year growth in revenue and profit across all industries: quarterly sales increased by 14.3% year-on-year, ordinary profit surged by 52.1%, and net profit skyrocketed by 68.1%, with profit growth rates remaining high across all metrics.
By sector, the manufacturing, non-manufacturing, and financial industries all experienced a full recovery with no apparent weaknesses. The manufacturing sector's ordinary profit growth led the market, showing the most prominent earnings recovery. There was a common misconception in the market that the current earnings growth of Japanese companies was heavily dependent on the semiconductor AI track. However, actual data shows that the AI dividend has completed its diffusion from the core track to the entire industry chain, with the support base for earnings growth being extremely broad. Although Kioxia alone contributed 9.7 percentage points of the market's total ordinary profit increase, accounting for 20% of the overall profit growth and being a core source of incremental gains, companies like Panasonic, Renesas Electronics, and KOA also saw significant earnings improvements, confirming that AI capital expenditure is continuously penetrating into adjacent areas such as substrate materials, electronic components, factory automation, industrial machinery, and power equipment.
In terms of earnings achievement, the resilience of the market's fundamentals has been further verified. The achievement rate for the full-year earnings guidance for the first quarter was 30.4% for both the manufacturing and financial sectors, and 28.4% for the non-manufacturing sector. The achievement rates for all three major sectors were significantly higher than the historical quarterly average of 25%, indicating that the earnings growth of Japanese companies is sustainable and not a short-term pulse rebound. From an industry perspective, construction, chemicals, precision instruments, banks, automobile manufacturing, and general trading companies were the core contributors to earnings, while the earnings of companies in sectors like electric power and gas, some airlines, real estate, and low-end manufacturing were relatively weak. The pattern of divergence between individual stocks and industries has solidified. Looking at pricing rules, historical data shows that after the earnings season, stocks with high earnings growth and excellent achievement of full-year guidance will continue to outperform the TOPIX index. The market has gradually absorbed the pure thematic premium, and stock prices are now highly correlated with the company's actual earnings momentum and valuation alignment. Fundamental quality has become the core dividing line for individual stock performance.
Policy and Exchange Rates: Coordinated Intervention Reshapes Policy Cycle, Benefiting Long-Term Market Recovery
The coordinated foreign exchange intervention announced by Japan and the US in August 2026, along with the activation of the Federal Reserve's FIMA Repo Facility, have become core macro variables affecting the Japanese stock market, forex market, and monetary policy, completely changing the medium-term operational logic of the market. The market once interpreted the FIMA facility as providing Japan with unlimited ammunition for foreign exchange intervention, which could potentially reverse the yen's depreciation trend. However, considering the facility's rules and Japan's fiscal situation, this expectation appears to be significantly biased. The FIMA Repo Facility is a liquidity tool backed by foreign debt, not an unlimited source of funds. Japan must use its domestic dollar-denominated assets as collateral to obtain dollar liquidity, and the financing cost is 25 basis points higher than the market benchmark rate, making the cost of capital relatively high and preventing its unlimited use. The ammunition for foreign exchange intervention has a clear boundary.
Therefore, simply relying on expanding the facility cannot reverse the medium-to-long-term trend of the US dollar against the yen. The consistency of policy communication and fiscal discipline are the keys to the effectiveness of the intervention. From a deeper fiscal fundamental perspective, the Japanese market still has long-term concerns. The current ratio of Japanese government debt to GDP far exceeds all G7 member countries, with fiscal balance remaining persistently weak. Although the fiscal situation has marginally improved, there has been no substantive reduction in spending. Relying solely on small tax adjustments cannot compress the fiscal risk premium, which also determines that the yen exchange rate is unlikely to experience a sustained unilateral appreciation. The forex market will maintain a volatile recovery pattern.
However, this coordinated Japan-US intervention is a substantive positive for the normalization of the Bank of Japan's monetary policy. The prolonged loose monetary policy has been one of the core drivers of the yen's weakness. The desire for exchange rate stability will pressure the Bank of Japan to exit its easing stance and advance its interest rate hike cycle. The rising expectation of monetary policy normalization has two main benefits. On one hand, it directly benefits the banking sector, as net interest margin repair will continue to enhance the earnings resilience of bank stocks, making them a stable ballast for the market. On the other hand, increased policy certainty will attract global capital to increase allocations to the Japanese equity market, providing incremental capital support for the market.
Core Risk Assessment: Two Variables Cap the Market's Upside
While the market turning point is confirmed and structural opportunities are prominent, the core downside risks for the Japanese stock market are not the widely watched foreign exchange intervention. Instead, they are oil price volatility and the acceleration of rising long-term interest rates in Japan and the US. These two variables will be the key factors suppressing market performance in the second half of the year. Firstly, the risk of sharp oil price volatility caused by geopolitical conflicts. The tense geopolitical situation in the Middle East, with repeated disruptions to shipping through the Strait of Hormuz, continues to disturb the global crude oil market. Two-way, sharp oil price fluctuations increase global market volatility. For Japan, which is highly dependent on energy imports, rising oil prices will directly increase manufacturing costs, suppress the space for corporate earnings recovery, and at the same time, imported inflation will constrain the flexibility of monetary policy, creating multiple negative pressures on the stock market. Secondly, the risk of valuation compression from rising long-term interest rates in the US and Japan. The current policy path of the Federal Reserve is unclear, with market expectations for subsequent rate hikes or cuts being chaotic. The yield curve for US Treasuries is steepening, and interest rate volatility continues to rebound. The widening of CDS spreads for global cloud computing companies is tightening financing conditions for the AI industry, directly suppressing global willingness to invest in AI capital expenditure and impacting the valuations of companies in the Japanese AI industry chain. Simultaneously, Japan's long-term interest rates are rising in tandem with US Treasuries, further compressing the valuation space of the equity market. In the short term, ahead of the Jackson Hole Global Central Bank Symposium in August 2026, there is high uncertainty surrounding core US economic data such as CPI and non-farm payrolls. Global financial market volatility is expected to remain elevated, and the Japanese stock market will likely continue its volatile and divergent trend, making a unilateral upward trend difficult to commence quickly.
Future Allocation Strategy: Abandon Single Tracks, Diversify into Structural Alpha
Combining the market style shift, fundamental structure, policy cycle, and risk variables, current investment in Japanese stocks needs to completely abandon the previous single strategy of heavily weighting core AI growth stocks. The approach should shift towards prioritizing earnings certainty, diversifying into low-valuation areas, and avoiding thematic premium bubbles. Focus on three high-value allocation directions. First, focus on cyclical value sectors benefiting from the spillover of the AI dividend. As AI capital expenditure spreads from the core semiconductor track, the earnings momentum of sectors like factory automation, engineering machinery, power equipment, industrial machinery, and defense equipment continues to be released. These sectors offer the triple advantages of low valuations, high earnings certainty, and upward industry sentiment. At the same time, the banking sector, as a core beneficiary of monetary policy normalization, can enjoy the benefits of net interest margin repair from the interest rate hike cycle while hedging against the concentration risk of AI stock holdings, making it a high-quality choice for a portfolio's core position. Second, increase allocations to high-quality domestic demand leaders with low AI correlation. Large-cap, high-quality domestic companies in sectors like retail, IT services, and gaming derive their performance primarily from domestic demand and their own operations. Their correlation with the AI tech track is extremely low, effectively allowing them to avoid valuation volatility risks in the tech sector. Against a backdrop of increased market volatility and heightened style divergence, these stocks, with their stable earnings and reasonable valuations, can significantly enhance the downside resilience of an investment portfolio and generate stable alpha returns. Third, select individual stocks using a quantitative fundamental model and avoid underperforming names. Screen stocks based on four core dimensions: the magnitude of earnings recovery, full-year guidance revisions, valuation expectation gaps, and previous valuation changes. Prioritize high-scoring stocks like Shimizu Corp, Mitsubishi Chemical Group, Panasonic Holdings, and Murata Manufacturing, which have earnings that beat expectations and reasonable valuations. Avoid low-scoring names in sectors like electric power and gas, some pharmaceuticals, low-end machinery, and real estate, which have low earnings achievement and overextended valuations, to avoid structural pullback risks.
Summary and Outlook
In the second half of 2026, the Japanese stock market has officially completed its historic style shift. The once-in-three-decades momentum factor has been fully cleared, marking the end of a theme-driven broad market rally and the beginning of an era of refined stock selection dominated by earnings momentum. Looking at fundamentals, robust earnings growth across all industries and the widespread diffusion of the AI dividend provide solid support for the market. From a policy perspective, the coordinated Japan-US intervention is propelling the Bank of Japan's monetary policy normalization, offering long-term recovery opportunities for value sectors like banks. On the capital flow front, with speculative capital cleared out, incremental funds are concentrating on high-quality, outperforming stocks, and structural opportunities continue to expand. Overall, the current Japanese stock market presents more opportunities than risks. However, index-level rallies are unlikely to re-emerge, and structural divergence is the core norm. The core logic for subsequent investment will continue to focus on earnings certainty, valuation reasonableness, and the sustainability of industry growth. By diversifying holdings across AI-spillover cyclical stocks, domestic demand leaders, and financial value stocks, while avoiding risks from rising oil prices and interest rates, investors can capture the new alpha opportunities following this adjustment.
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