Thoughts on the N225, EAFE and EWJ

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Thoughts on the Nikkei 225 Stock Average:

Japanese stocks have been rallying over the past several weeks and the benchmark Nikkei 225 Stock Average is now at a 2-month-plus high; the N225 recouped 14,000 last Friday in spite of thin trading of late, due to the extended holiday that continues through this Tuesday. Short-term, sentiment has improved drastically as buyers have emerged to pick up stocks with severely depressed prices and the kind of valuations that excite Warren Buffett; but Japanese stocks are susceptible to profit-taking, given the recent 20% gains after having fallen close to 40% in about a year’s time (peak to trough). However, the Nikkei is still some 20% off the 18,000-level it reached last July and to keep it all in perspective, 40,000 was in sight in late 1989 before the Nikkei bubble burst. The Nikkei lagged regional and global benchmarks by a wide margin in 2007, after somewhat of a disappointing, although, positive 2006. Few remember the surge in the second-half of 2005. In summary, the Nikkei’s recent drop to the unimaginable 11,000-level was certainly overly pessimistic and while short-term volatility is to be expected, investors with patience will likely be rewarded handsomely as shares recover prior price levels and potentially more, pending the health of the global economy and domestic issues such as improvements in corporate governance.

Thoughts on Japan and EAFE:

Japan’s weighting should be gradually diminishing in such benchmarks/indices as EAFE, while simultaneously, the weighting of Asia (ex-Japan) increases. This is largely inevitable due to the comparatively lower growth rates in Japan. That said, the capitalization of Japanese equities is still huge by world standards and thus, Japan warrants at least the low-end of its 20%-plus allocation.

Thoughts on how to play Japan (EWJ):

While it is inadvisable to hold a significant portion of any single stock or country index in one’s portfolio, there are times when it may make sense to be overweight a stock and/or indices. Given the extremely oversold levels in Japan earlier this year and in spite of the recent rally, now may be one of those times to justify overweighting Japan. Not only do valuations remain attractive broadly across the Japanese stock universe, but there are several potential catalysts that I believe could lead to impressive gains like those witnessed in the second-half of 2005. Unfortunately, individual investors’ arsenals are limited as to how to best play Japan. Most Japan-focused ETFs are too thinly traded, while most mutual funds charge comparatively high fees. In addition, there is the impact of the yen, which is a double-edged sword, since a weak yen is viewed favorably in Japan, but hurts U.S.-based investors’ returns (as it did in ’05). In light of all this and until a better alternative emerges, iShares MSCI Japan Index ETF [[EWJ]] continues to be the most logical investment choice.