How the Nikkei Stock Average became skewed

Updated : 17.05.2017 / Category Economy

Japanese market players frequently gripe about the timing of Fast Retailing Co., Ltd.'s release of its earnings reports.

Fast Retailing, which operates the Uniqlo clothing store chain, releases an earnings report on the second Thursday of each new quarter. This tends to influence the Nikkei Stock Average's special quotations for index futures and options, which are calculated after the stock market opens on the second Friday. The release of special quotations is sometimes delayed and its figures often deviate from the actual Nikkei Stock Average.

Fast Retailing is not to blame for this. The problem lies with Nikkei Inc. Observers have long pointed out that Fast Retailing carries a relatively heavy weight in calculating the Nikkei 225, but the problem does not stop there.

Many individual investors feel the Nikkei is generally higher than their assessment of the stock market. To substantiate their observation, this writer compared the price-earnings ratio (PER)--the ratio of a company's share price to its per-share earnings--based on the weighted average of market capitalization with the PER by examining the indexes since 2012. On average, the PER based on indexes, which the Nikkei depends on, was 25 percent higher than the PER based on the weighted average of market capitalization.

Calculation method bizarre

The Nikkei 225 is a strange index indeed. Even if Toshiba Corporation stock, which is trading for about \200 per share now, were to become worthless, the Nikkei would fall only by 8 points. Similarly, if Resona Holdings, Inc. stock, which is traded for \600 per share, were to likewise become worthless, the Nikkei would slip only 2 points. However, if Fast Retailing reaches the maximum allowable single-day gain, the Nikkei will jump by 300 points.

As of early April, Fast Retailing carried a 7.05 percent weight on the Nikkei 225, followed by SoftBank Group Corporation (4.74 percent), KDDI Corporation (3.46 percent), Kyocera Corporation (2.50 percent), Tokyo Electron Limited (2.49 percent) and Daikin Industries Ltd. (2.24 percent). The top four "heavyweight" companies combined account for 20 percent of the Nikkei average, while the top ten companies swallow up one-third.

How about major companies in the auto industry, a vital sector of the Japanese economy? Nissan Motor Corporation's weight is a mere 0.21 percent, trailing Honda Motor Co., Ltd. (1.34 percent) and Toyota Motor Corporation (1.21 percent).

The banking sector carries even less weight on the Nikkei index. Mitsubishi UFJ Financial Group, Inc.'s weight is 0.14 percent, while Sumitomo Mitsui Financial Group, Inc. is 0.08 percent and Mizuho Financial Group, Inc. is 0.04 percent. Even if Mizuho Financial Group were to collapse, the Nikkei would only drop by 8 points. Comparison with the Dow Jones Industrial Average will demonstrate how skewed the Nikkei is. As of April 20, the Goldman Sachs Group stock's weight, one of the heaviest among the 30 issues of the Dow Jones at 7.5 percent, was 7.5 times heavier than General Electric Company stock, the lowest at 1 percent. The gap between the heaviest and lightest stock on the Nikkei is more than 700 times.

How are these figures derived? The Nikkei differs from other major stock market indexes around the world. The Standards & Poor's 500 index and the NASDAQ Composite Index of the United States, Germany's DAX Index and Hong Kong's Hang Seng Index, among others, are based on a weighted average of market capitalization (a measurement of business value based on share price and number of shares outstanding). The Nikkei started out as the Nikkei Dow Jones Stock Average, adopting the Dow Jones method that does not factor in market capitalization. But after several twists and turns, the Nikkei adopted the so-called presumed value method in 2005.

The par value system was abolished in revisions made to the Commercial Code in 2001. The system set the values of stocks at prices such as \50, \500, \5,000 and \50,000. The Nikkei adopted the system, and the presumed value, usually \50, was set for each component. Stock with a large presumed value and a low stock market value will have a low weight in the Nikkei. For example, Tokyo Electric Power Co. Holdings, Inc.'s weight in the Nikkei is 0.01 percent because its stock's presumed value is \500, but its stock price is around \400. Conversely, if the presumed value is small and the stock price is high, a company will have more weight in the Nikkei.

Experts say this bizarre stock price index is unparalleled in the world. Because of its calculation method, some major Japanese companies, such as Nintendo Co., Ltd., Murata Manufacturing Co., Ltd., Orix Corporation and Recruit Holdings Co., Ltd., whose market capitalization amounts to between \2 trillion and \4 trillion, are not part of the Nikkei index. The reason is their stock prices are too high.

Why the Nikkei is rising

Though distorted as an index, it is difficult for the Nikkei to rise. When calculating the Nikkei, total stock prices are divided by a divisor. The smaller the divisor, the higher the Nikkei will become. The divisor is currently 26.301, the same level as it was in 1961 and showing no sign of becoming lower. By comparison, the Dow Jones divisor has dropped from 3.090 in 1961 to the current figure of 0.14.

Despite these structural impediments, the Nikkei has been on the rise. One reason for this is speculative buying of shares in Fast Retailing and other heavily weighted companies. The Bank of Japan's purchase of exchange-traded funds through trust banks also has been a factor.

Japanese media quote the skewed Nikkei 225 without fully understanding the index, while the government and the BOJ trumpet the rising Nikkei as an indication of economic growth. Closer scrutiny is advised when using the Nikkei as a guide for any investment.


This is a translation of an article from the May 2017 issue of Sentaku. The original article can be found here.