After Japanese equity valuations cooled, earnings divergence and sentiment shocks became the main positioning themes

Overview

This report reviews the changes in Japan's equity market in Q1 2026 across valuation, earnings revisions, flows, and style performance. Japan started the year strongly, but in March it fell about 13% on Iran-war-related risks, then rebounded about 7% from April onward. The report argues that the market has clearly de-rated and valuations are back in a more reasonable range, but the earnings upgrade cycle is showing signs of peaking and investor sentiment has also been hit. As a result, it is not advisable to make a one-way bet; instead, investors should keep a diversified barbell allocation with hedging characteristics.

Core views

The core views are: first, Japan's valuation has fallen from 17.3x forward P/E to 15.4x, close to the 10-year average, easing valuation pressure; second, earnings revisions are starting to diverge, with signs of peaking in discretionary consumer, financials, and technology, while communications and utilities remain in a down-revision cycle and staples, energy, healthcare, and materials still have room for further upgrades; third, foreign investors sold heavily in March, but extreme outflows may be followed by re-entry, and domestic institutions have recently turned net buyers; fourth, export stocks have performed better year to date, but domestic-demand stocks have stronger fundamentals, ROE, dividends, and buyback yields; fifth, the style approach remains a value plus GARP/QARP combination, with high dividend serving as a hedge against inflation and war risk.

Analysis framework

The report uses a quantitative strategy framework and breaks the Japanese market into six dimensions: valuation, earnings revisions, fund flows, domestic versus export exposure, sector scoring, and factor style. The sector framework is based on fundamental indicators such as sales growth, margins, earnings, ROE, capex, valuation, and balance sheet strength; style analysis compares factor performance versus the market, including GARP, earnings momentum, price momentum, value, growth, free-cash-flow dividend yield, quality, small cap, and high dividend.

Methodology notes

• Quantitative sector allocationJapan sector fundamental scoring framework

  Evaluate sector prospects using indicators such as sales growth, margins, earnings, ROE, capex, valuation, and balance sheets.

  This framework has a historical hit rate of about 62%. It currently gives positive signals for autos, technology hardware, materials, business and professional services, retail, banks, and insurance, while remaining cautious on durables and apparel, media and entertainment, transportation, and food and general merchandise retail.

• Style factor allocationValue + GARP/QARP barbell framework

  Use value and high dividend to hedge macro and inflation risks, while using growth, quality, and earnings revision exposure to capture upside.

  The report argues that value is cheap and out of favor, but the earnings downgrade cycle has not fully bottomed yet; quality is reasonably valued and the downgrade cycle is showing signs of a base; growth is reasonably valued but earnings revision signals are mixed, so a combined barbell remains superior to a single-style bet.

• Market sentiment and flowsMonitoring foreign investors, domestic institutions, retail investors, and yen shorts

  Assess Japanese equity sentiment and potential macro risk through fund flows and yen positioning.

  Foreign outflows in March reached about $52 billion, and domestic institutional flows are about -$33.5 billion year to date, but institutional sentiment has improved recently; at the same time, net yen shorts have continued to build, raising the risk of carry-trade unwinding.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Japanese domestic-demand stocks

  One of the core positioning legs

  Strengths

  Revenue growth, ROE, dividend yield, and buyback yield are all better than export stocks, and they more clearly capture the benefits of corporate governance reform.

  Weaknesses

  Year to date, overall performance has lagged export stocks, and some domestic-oriented industries such as software services and food and general merchandise retail have performed poorly.

  Comparison

  Compared with export stocks, domestic-demand stocks have stronger fundamentals and shareholder returns, but less short-term earnings upside.

  Risks

  Earnings support peaking, margin or capex deterioration, and an unsustained recovery in domestic fund flows.

• Japanese export stocks

  One of the core positioning legs

  Strengths

  They have outperformed domestic-demand stocks year to date, supported by semiconductors and capital goods; relative earnings revision upside remains higher than for domestic-demand stocks.

  Weaknesses

  Much of the currency tailwind from a weaker yen may already be behind us.

  Comparison

  Compared with domestic-demand stocks, export stocks have stronger near-term earnings revision sensitivity, but valuation and FX support are less favorable than before.

  Risks

  Yen strength, carry-trade unwinding, global demand slowdown, and geopolitical shocks.

• Japanese technology stocks

  Selective overweight idea

  Strengths

  Overall valuation is cheap, about 0.6 standard deviations below the 10-year average, and semiconductors, factory automation, and electronic equipment still have earnings upgrade potential.

  Weaknesses

  All subsectors are in a de-rating cycle, and valuation alone no longer provides meaningful support.

  Comparison

  Semiconductors, factory automation, and electronic equipment are preferred over IT services, software, and entertainment.

  Risks

  High-valuation subsectors continue to de-rate, and earnings revision momentum in software, IT services, and entertainment slows.

• Value and high-dividend stocks

  Defensive and inflation-hedging exposure

  Strengths

  Cheap valuation, low crowding, high dividend as a hedge against war and inflation risks, and yield plus quality momentum are still building.

  Weaknesses

  The earnings downgrade cycle for value stocks has not yet fully bottomed.

  Comparison

  Compared with growth and momentum, value is more defensive; compared with pure low-volatility, it offers better participation in policy normalization and high-dividend opportunities.

  Risks

  Persistent earnings downgrades, changes in the interest-rate path, and value traps.

• GARP/QARP

  An offensive positioning leg

  Strengths

  GARP is up 5.7% relative to the market year to date, and earnings momentum and price momentum have also been strong.

  Weaknesses

  During the March shock, GARP and QARP fell about 3% to 4% relative to the market, showing sensitivity to risk events.

  Comparison

  Compared with pure growth, GARP/QARP places more emphasis on earnings quality and reasonable valuation; compared with value, it offers more upside but less defensiveness.

  Risks

  Earnings revision peaking, crowded growth and momentum positions, and a decline in market risk appetite.

Key data

• Japan forward P/E17.3x down to 15.4xValuation has fallen back to roughly the 10-year average.
• Japan market performance in March 2026about -13%Iran-war-related risks created significant downside pressure.
• Japan market rebound since April 2026about +7%The market staged a partial recovery after the March selloff.
• Foreign outflow from Japan in March 2026-$52 billionDescribed in the report as the highest monthly foreign outflow on record.
• Domestic institutional fund flow year to dateabout -$33.5 billionHowever, domestic institutional sentiment has improved since March and there are signs of net buying.
• Year-to-date performance of export stocks versus domestic-demand stocksexport stocks +7%, domestic-demand stocks +1%Export stocks were supported by semiconductors and capital goods.
• Revenue growth of domestic-demand stocks versus export stocksdomestic-demand stocks 4%, export stocks -1%Domestic-demand stocks have stronger fundamental revenue growth.
• ROE of domestic-demand stocks versus export stocksdomestic-demand stocks 12%, export stocks 11%Domestic-demand stocks better reflect the benefits of corporate governance reform.
• Dividend yield of domestic-demand stocks versus export stocksdomestic-demand stocks 2.1%, export stocks 1.6%Domestic-demand stocks offer higher shareholder returns.
• Buyback yield of domestic-demand stocks versus export stocksdomestic-demand stocks 1.45%, export stocks 1.15%Domestic-demand stocks have a higher buyback yield.
• Year-to-date relative return of GARP+5.7%One of the best-performing style factors in Japan year to date.
• Year-to-date relative return of earnings momentum and price momentum+4.7% / +4.4%Momentum factors have shown stronger performance in Japan.
• Year-to-date relative return of quality and small cap-5.0% / -4.3%Among the weaker style factors year to date.
• Japan technology valuation17.2x forward P/E, about 0.6 standard deviations below the 10-year averageThe technology sector is generally cheap, but all subsectors are in a de-rating cycle.
• Rate hike probability55% in April, 88% in JunePolicy normalization and yen risks affect export-stock and value-stock positioning.

Impact & implications

For portfolios, the report leans against making a one-sided style or macro bet in Japan. There is room for valuation recovery, but the narrowing scope of earnings upgrades, foreign outflows, rising net yen shorts, and geopolitical risks have increased volatility. Positioning should therefore include both domestic-demand stocks, which benefit from corporate governance, dividends, buybacks, and domestic resilience, and export stocks, which still have relative earnings improvement potential; at the sector level, favor autos, technology hardware, materials, retail, banks, and insurance where fundamentals have improved and earnings support is stronger; on styles, use high dividend and value for defense, and use GARP/QARP, growth, and quality to capture earnings improvement.

Risks

• A renewed escalation of Iran-war and broader geopolitical risks.
• Japan's earnings upgrade cycle peaks, especially in discretionary consumer, financials, technology, communications, and utilities.
• Foreign investors continue to sell Japan and domestic institutional buying does not persist.
• Accumulating net yen shorts increase the risk of carry-trade unwinding.
• A change in the policy normalization path affects the yen, export stocks, and value stocks.
• Technology subsectors continue to de-rate, and valuation recovery cannot offset slower earnings revisions.
• High-dividend and value stocks may face the risk that earnings downgrades have not yet bottomed.

What to watch

• Whether Japan's forward P/E stabilizes around 15.4x or gets de-rated again.
• Whether foreign investors return to Japanese equities after the record outflow.
• Whether domestic institutional flows remain positive.
• Net yen short positioning and signs of carry-trade unwinding.
• Changes in the Bank of Japan's April and June rate-hike probabilities.
• Whether earnings revisions in staples, energy, healthcare, and materials continue.
• The strength of earnings revisions in semiconductors, factory automation, and electronic equipment.
• The relative performance of GARP, earnings momentum, price momentum, high dividend, and quality factors.
• Whether the signals for autos, technology hardware, materials, retail, banks, and insurance remain green in the sector scoring framework.