Triple Whammy In Investing In Japanese Equities

Jan.14.13 | About: WisdomTree Japan (DXJ)

Now that prime minister Abe practically declared his own currency war by setting a 2% inflation target and on top of that promises to spend 10.3 trillion of Yens on infrastructural and defense projects, I see huge potential in Japanese equities. Since most of the financial articles are focusing on US markets, common commodities like oil, gold, silver, etc. and popular FX pairs, I think this opportunity is not finding itself a prime time spot.

We have seen the effect of money pumping in equity prices repeatedly during the last two decades. Examples include Japan's previous attempts of stimulus in the past, and US QEs after the 2008 crises. All printed money practically flowed into some sort of secondary market investment, notably equities, bonds, commodities. We should expect a similar event in Japanese equities. Since November, Japanese equities appreciated 20% while the Yen lost 10% value against USD. I conjecture that this appreciation in Japanese equities and devaluation of the Yen will continue throughout 2013 given the determination of the new Japanese government. At the moment Nikkei is where it was in 1984, at 10,800. To see where we came from, it is important to note that its all time high is 38,900.

I don't, however, claim that the stimulus will work (or not) and kickstart the Japanese economy. The previous attempts did not. Nevertheless we have listened to many talking heads regarding how US stimulus packages will fail or how expensive the market is based on this and that P/E ratios. None of that did stop US equities from rallying off of their bottom. Excess liquidity will always find its way to the equity market for some quick bucks. For those who missed the opportunity in US equities starting from 2009, here is your chance once again.

What about the triple whammy?

The devaluation in Yen will have several effects:

First of all Japanese export giants like Toyota (NYSE:TM), Nissan (OTCPK:NSANY), Sony (NYSE:SNE), etc. will benefit from increased sales and/or better sales price (they can increase their prices in Yen without changing it in dollar terms) with respect to their local costs in Yen that they pay to their employees (at least to those who are in Japan), utilities, etc. This will automatically cause an increase in valuation denominated in Yen, which is also the currency the stocks are quoted in.

Secondly as the Yen loses its value, Japanese equities will look a lot cheaper to foreign investors, since they can buy more shares for the same dollar/euro. This will cause a rush into Japanese equities.

Based on the above two, it is logical to invest in Japanese equities especially into those companies whose sales are mostly abroad, not in the Japanese local market.

However in order to invest in Japanese equities one should convert dollars/euros into Yen first and then buy shares of such companies. This will have a negative effect on the profits due to the devaluation of Yen. Profits that you will make on the equities will be partially (I expect a higher yield on equities than devaluation) eaten away by your FX losses.

One way to eliminate this effect is to hedge against the Yen. Luckily you don't have to do all the work yourselves. There is an ETF that does it for you: WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ).

But I prefer an alternative option, which I call the third whammy. Instead of investing in these equities or any ETF, I would go with derivative instruments. CME has Nikkei index futures in both USD and Yen. Sensible investing is about capturing premiums in the market. Go long on USD denominated contracts and free-ride on the short position holder. As a bonus whammy, Nikkei index futures are in backwardation, which means you will not have to roll contracts at a higher price. But that situation may change, so you may consider not the front contract but later contracts such as June or December (when it gets liquid).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long on Nikkei index.