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Japan’s Nikkei is at risk of falling back to a 26-year low as a deep recession and strong yen take a heavy toll on company earnings, overwhelming valuations showing shares at some of the cheapest levels on record.

Even after the Nikkei’s record 42 percent tumble last year, overseas portfolio managers are likely to be slow in embracing Japan again, having dumped about a quarter of their $276 billion in stock purchases made between 2005 and 2007.

“Demand is dropping fiercely for companies,” said Takashi Ito, a senior strategist at Nomura Securities.

But based on analysts’ earnings expectations, Japanese shares are still more expensive than the United States and Europe despite having suffered a bigger slide than those markets.

A corporate culture where firms hold shares in each other is one reason why valuations have been historically higher in Japan than other regions.

In the business year ending in March 2010, the price-to-earnings ratio of the top 500 Japanese companies is seen at 12.25 times compared with 14.13 for the current year, according to Thomson Reuters data.

That is still higher than the 10.88 forward P/E ratio for S&P 500 companies this year, and the single-digit levels some analysts see in European indexes such as Germany’s DAX

The yen’s record surge last year has added to the pain from the global economic downturn for top Japanese exporters such as Toyota Motor Corp, which called the current climate an unprecedented emergency in its 70-year history saving payday loans.

On a trade-weighted basis, the yen soared 25 percent in 2008, shocking Japan’s big companies and taking a big slice out of the value of already tumbling overseas profits.

Electronics giant Sony Corp will likely suffer an operating loss of about $1.1 billion — its first in 14 years — due to sluggish sales and the stronger yen, a source with knowledge of the matter said on Tuesday.

Highlighting how sharply the Nikkei slid, the price-to-book ratio — or much much the market is valuing companies compared to the value of their net assets — remains at just 1 after sliding to 0.87 last October when the stock index hit a low of 6,995.

Such levels are rare, indicating investors are valuing firms at less than what they could theoretically be liquidated for.

The drop to 0.87 was the lowest since 1991, according to figures from Thomson Reuters. Even during Japan’s decade of economic stagnation, deflation and banking crisis, the price-to-book ratio never fell below 1.

But analysts don’t think buyers will be swayed just yet.

“Unless investors can confirm the economy and corporate earnings will likely soon hit the bottom, buying based on those valuations won’t take place,” said Yutaka Miura, a senior technical analyst at Shinko Securities. 

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