Value investors will still find excellent valuations in Japan despite the market’s gains over the past several weeks. As I say again, in my latest exclusive at Seeking Alpha, “Investing in Japan Beyond the Platitudes,” the most interesting opportunities are in domestic-demand small/mid-cap companies. I’ve received a number of messages asking about WisdomTree’s hedged Japan Equity fund (DXJ). Yes, DXJ has done well, much better than iShares Japan (EWJ), in this rally. However, I’m not a big fan of DXJ for some of the same reasons I don’t like EWJ. Over 270 portfolio holdings for DXJ and 300 for EWJ mean outside of the top-few positions no one stock is really going to move the needle; the top holdings are not dissimilar from the benchmark indexes nor the one-trick pony mutual fund managers. Exporters are already cyclical and the demand/supply (selling) of their shares only makes them more cyclical — this is even more a concern should positions get closed en masse in DXJ given its smaller asset base that has surged only recently.
Finally, I don’t see the yen “blowing up” — it’s not as simple as some may wish or have been led to believe to see a currency like the yen or a country like Japan “blow up” in a straight line. Beware macro pontification coattailing. The great 2005 Nikkei rally saw a roughly 10% weakening of the yen. Overnight, Economy Minister Akira Amari warned excessive yen appreciation may benefit exporters but would hurt people’s livelihoods. The business press is concluding Minister Amari as having suggested the yen has weakened enough. In fact, too weak of a yen begins to hurt exporters if materials costs don’t start to decrease. In this sense, the input environment is quite different than ’05; ditto the strength of the global economy now vs. then.
“China poised to pass Japan as world’s No. 2 economy,” reports CNN.com. Q2 GDP figures from Japan and China show the latter exceeding the former, $1.34 trillion vs. $1.29 trillion. In 2009, it was Japan ahead for the full year, at $5.07 trillion compared to China at $4.91 trillion, according to the IMF. Given the two lost decades now in Japan, this was only a matter of time. Jesper Koll’s (veteran Japan economy expert now with JP Morgan in Tokyo) simple forecast (see quote below) represents a real and substantial opportunity for Japan. This is not a new idea or sudden realization by any means, but it is far more tangible now than ever before; it is becoming more palpable given recent developments such as the Japanese government actively courting Chinese tourists.Continue reading
The DPJ’s rise (and the LDP’s fall) is no longer debate material, but a welcome reality. As expected, the yen exhibited strength, and looks poised to test ¥92. The Nikkei meanwhile was quite volatile, gapping up, hitting a new ytd high at 10,767, tumbling into the start of the afternoon session to a low of 10,423, to close down 0.4% at 10,492. The star of the day, if you will, was the Jasdaq, up 1% to 50.49, right around its ytd high. Of course, now that the DPJ is in power, the real challenge is to keep campaign promises and stick to them, even if there is near-term pain — rather than postponing the pain as has often been the case.
In terms of the markets and forex, the DPJ has almost certainly created a situation for further yen strength (and sustained relative yen strength after everyone piles into the trade and eventually moves on). Domestic-demand stocks, while not immune to certain negative externalities of a strong yen, are likely to be favored over exporters. The exporters, whether they like it or not, will have to get accustomed to a stronger yen. To summarize the first day of trading after Japan’s historic election, it is suffice to say that politics is front and center as it should be, but the market reaction was diluted by both a dose of reality and by the 6.7% selloff in Shanghai.
Interesting developments in the Nikkei ahead of the parliamentary election at the end of this month, which at this point looks as if it will finally bring an end to LDP rule. A foreign exchange rate of $1/¥94 would have been practically inconceivable prior to the “Lehman shock” (as the Japanese refer to the genesis of the financial crisis), let alone a stock market rally. And now, ahead of what appears to be a DPJ (opposition party) that will let the yen appreciate and focus more on domestic demand (rightfully so), the stock indices are showing no fear of the yen.
A sustained rally in conjunction with even more yen appreciation bodes especially well for the domestic-oriented stocks, of which there are plenty — many that still have saliva-inducing valuations. However, exporters remain the headline grabbers, and it is not clear just how much yen strength can or will be tolerated (one suggestion is ¥87 is the trip wire, a level reached early this year, and a level not seen previously since the mid-90s). That being said, again what makes this all very interesting is that although the strong yen makes Japanese exports less competitive (great instead for instance, for South Korea [[EWY]], it does allow them to invest more in production overseas, a win-win for the Japanese and local FDI recipient economies.
What worries me though is the pace of reform(s) versus expectations, assuming a DPJ victory. Meantime, there is no debating the fragility of the domestic/global economy and the recovery thus far in equities. Domestic and overseas investors are very fickle and just as quickly as money has been flowing in, it can reverse course equally as quickly. The seemingly conservative, opportunistic play would be to go long the yen [[FXY]]. The DPJ’s financial advisors (and by extension, one of them possibly being tapped as finance minister) have already gone public saying they don’t intend to intervene in forex, except in extraordinary cases. Another play would be to look at the smaller-cap funds like [[DFJ]] and [[JSC]], but unfortunately, these are not very liquid and are quite fragmented. Time-permitting I will look at posting some specific stock picks.
At the time of publishing, the author does not own any long/short positions in the funds mentioned.