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updated 1/18/2006 2:00:49 PM ET 2006-01-18T19:00:49
NEWS ANALYSIS

Taisho Nishimuro, who had a distinguished career as president and chairman of Toshiba, likely had no inkling of the melodrama in store for him when he became chairman of the Tokyo Stock Exchange last year. For over the last four months he and the world's second-biggest exchange have lurched from one crisis to another. Indeed, on Jan. 18, he found himself explaining to Prime Minister Junichiro Koizumi why the TSE had halted trading for only the second time in its 50-year-plus history.

The quick answer to why the bourse stopped trading 20 minutes before close was an overpowering wave of sell orders related to an Internet company that few outside of Japan have ever heard of -- a boom-and-apparently-bust outfit called Livedoor. Just two days ago, prosecutors raided it looking for evidence of alleged financial improprieties involving the booking of one merger by a subsidiary and possible doctoring of earnings.

Not just one company
The dump-Livedoor frenzy, which dragged other Japanese Net stocks such as Softbank and Yahoo! Japan, drove the overall market into the muck. The Nikkei 225 stock average fell 464.7 points, to 15, 341, or nearly 3%, in the shortened session. Nishimuro assured investors that the bourse will open for trading at 9 a.m. tomorrow. If so, it's likely to be a hairy day for investors who watched in awe as the Nikkei climbed some 40% last year. The scent of fast money that hung over the TSE in the closing days of 2005 has been replaced by a palpable sense of fear that 2006 could see a very nasty correction.

Livedoor might just be the trigger to broader sustained declines. And the reason for that has less to do with that company, whose own market value has collapsed and which faces a protracted legal brawl with government prosecutors, and more to do with sky-high valuations across many sectors of shares that a number of analysts were fretting about in the closing months of 2005.

Sparked by real signs of economic recovery (Japan's current expansion started in 2002 and shows no signs of losing steam), global portfolio investments rifled into Japanese stocks through much of 2005. Foreigners snapped up nearly $80 billion worth, a tsunami of money from abroad not seen since 1999. Online trading has been booming too, and the current rage in Tokyo among the tech-savvy set is text-messaging trades via sleek, clamshell-shaped, Web-enabled cell phones. In short, the trading sentiment in Tokyo has been on the frothy side for some time.

Polarizing figure
With Japanese stock price-earning ratios hovering around 29 based on forecasted 2006 earningers, vs. 18 or so for S&P 500-stock index shares, some brokerages started warning their clients the party wouldn't last much longer. In early December, Credit Suisse First Boston warned clients to cut their investment weighting in Japan. Another sign of nervousness: The popular iShares Japan Index Fund, a $10 billion exchange-traded fund run by Barclays Global Fund Advisors was heavily shorted on the American Stock Exchange in November.

Clearly, short-term forces are work. The Livedoor scandal could cast an unflattering light on Japan's entire Internet sector. Besides Yahoo! Japan and Softbank, Rakuten, Japan's biggest online retailer, also saw its stock plunge. As the Livedoor investigation drags on, the spotlight will remain on its founder, Takafumi Horie, a polarizing figure in Japan. Many in Japan Inc. see him as a dangerous upstart, while others had hoped he would shake up the Establishment. If Horie falls in a spectacular fashion, it could trigger more market tremors in the future.

The Livedoor effect is amplified by the fact that a number of Livedoor equities trade separately, and were all hot stocks. Now they're crashing, too.

Work to be done
The Livedoor scandal isn't the only thing spooking Japan's tech sector. Intel's so-so earnings report had its impact too, as did jitters about Yahoo in the U.S. Shares in Tokyo Electron, which supplies chip-production equipment to Intel, also fell. So did Toshiba and Rohm, a maker of customized semiconductors. The mess spilled over to other Asian markets as well: The tech-heavy bourses of Taiwan and Korea had a scary Tuesday as Tokyo was melting down.

Aggravating the fear factor is the TSE's desperate struggle to restore its credibility. Heavy trading volumes basically crashed the exchange's trading system back in early November. A month later, a series of trading errors by both the securities arm of Mizuho Holdings, a giant financial institution based in Tokyo, and the TSE caused colossal embarrassment. As a result, TSE President Takuo Tsurushima resigned to take responsibility for the mishaps soon after.

Nishimuro has moved into that job as well as serving as chairman. Obviously, plenty of work needs to be done. But he can't do much if this week's declines are the beginning of a nasty shakeout to get Japanese stock evaluations more in line with Japan's economic outlook and international norms. Things are undoubtedly looking up for Japan: Most economists see growth of 2% or so in 2006. (Remember, just three years ago, the Nikkei was hover at 20-year lows around 7,600.) And a bit of a shakeout wouldn't be such a bad thing, either.

Yet the Nikkei is clearly entering a stomach-churning stretch. Nishimuro may well be wondering if he should have opted for gentlemanly retirement after Toshiba.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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