Is the Sun Rising for Japanese Equities?

By Brandon Clay

While Japan is the second largest economy in the world, investors seem to have passed the island nation over in favor of other Asian markets, particularly China. Japan’s export-dependent economy has been hampered for years by artificially low interest and monetary policy that can only be deemed foolhardy. In addition to China, investors have favored smaller Asian markets such as South Korea, Singapore, and others over Japan. This is a telling sign of how far Japan has fallen off of investors’ radars.

Things have gotten so bad for Japan that one could argue Japanese stocks have been in a bear market for nearly two decades. In fact, we’ve lamented the ill fortunes of Japan’s economy in the past, talking about the slack economic output earlier this year.

All that said, things may be looking up Japan. For US-based investors, there are ten ETFs that focus on Japan, with iShares MSCI Japan Index (EWJ) being the most popular. EWJ has lagged the S&P 500 year-to-date, but that’s not really surprising. What you may not be aware of is that Japanese stocks have actually been doing better than their US counterparts since the first quarter of 2002 (more than seven years). The one-year return of EWJ has been about the same as the S&P 500, though not nearly as volatile.

There are some fundamental factors that Japan’s economy has in its favor (for once). Japan is benefiting from eased tensions between China and Taiwan. Japan actually counts China as a larger trading partner than the USA at this time. Japan’s close proximity to China, combined with its status as a prime exporter of products that China’s burgeoning middle class will crave (think TVs and automobiles) make Japan a compelling indirect China play.

Some press reports also noted that Japan’s money multiplier is positive for the first time in more than two decades. This is yet another positive sign. Political change in Japan may be afoot with the Democratic Party of Japan gaining some ground against the Liberal Democratic Party. Some Japan observers argue they’ve been in power for far too long.

EWJ’s top holdings are makers of products many stateside investors are familiar with. Toyota Motor (TM) is the ETF’s largest position, and other familiar top holdings include Honda Motor (HMC), Tokyo Electron, Nintendo (NTDOY.PK), Sony (SNE), Canon (CAJ), and Panasonic (PC). Consumer discretionary is the largest sector at 19.6%, followed by industrials 18.8%, financials 17.6%, and technology 12.8%.

All of the positive fundamentals that may boost Japan’s economic fortunes could take a while to play out. Therefore, it may not be reasonable to expect EWJ, or other ETFs that invest in Japan, to produce outsized returns in the near-term. We have focused on EWJ in this discussion, as it is the most liquid ETF of the ten Japan ETFs listed below. Some of the others have very sparse trading activity, so be sure to check volume and bid-ask spreads before placing your trade.

1. iShares MSCI Japan (EWJ) (fund overview)
2. iShares MSCI Japan Small Cap (SCJ) (fund overview)
3. iShares S&P/TOPIX 150 (ITF) (fund overview)
4. PowerShares FTSE RAFI Japan (PJO) (fund overview)
5. ProShares UltraShort MSCI Japan (EWV) (fund overview)
6. ProShares Ultra MSCI Japan (EZJ) (fund overview)
7. SPDR Russell/Nomura PRIME Japan (JPP) (fund overview)
8. SPDR Russell/Nomura Small Cap Japan (JSC) (fund overview)
9. WisdomTree Japan Small Cap Dividend (DFJ) (fund overview)
10. WisdomTree Japan Total Dividend (DXJ) (fund overview)

Disclosure: No positions

Comments

[Mad Hedge F...:]

I'd rather play the long side somewhere else. I drove over the Benicia Bridge today, passing over ships unloading Toyotas from Japan. The company’s entire product line was there, from Lexus to Prius to Corolla, baking in the sun, still wrapped in plastic, and unsold by the thousands, the victims of a 40% YOY sales drop. So it was no surprise when the Bank of Japan informed us that wholesale prices in June fell a gob smacking 6.6% YOY, confirming the most dire forecasts that the country is still in the grips of a nearly 20 year economic ice age. This is why the US is not headed for the same big freeze, as many Cassandras are predicting. Japan’s bail out of its banks was a slow motion affair stretched out over eight years. Treasury Secretary Hank Paulson pulled the trigger on a much bigger bazooka with the TARP, a month after Lehman went bust, and Secretary Tim Geithner and the Fed’s Ben Bernanke followed up with their 155 mm howitzer. Tokyo’s insiders made sure well connected “zombie” borrowers have stayed alive to this day. The truly great strength of the US is that creative destruction is a constant, unrelenting, and unstoppable force, enabling the economy to bury its mistakes quickly and move on to the next game. Look at GM. Japan’s fiscal stimulus was an impotent, irregular drip of inadequate packages financing bridges to nowhere. Obama’s hurricane of a $2 trillion budget in his first month provided more stimulus than Japan did in ten years in GDP terms, and now there is the threat of a second package. The bottom line is that Japan never understood the true debacle they were into until it was too late to do anything about it. The US realized in September we were on the precipice of a Great Depression II, and have thrown in everything, including the kitchen sink, to stop it. The US recession may be long and brutal, and the recovery subpar, but we are definitely not looking at Japan’s two lost decades.

Jul 21 09:42 AM

[HaavBline:]

Agree with Mad. I' drather play the long side somewhere else.

Author did not present any compelling reasons to buy Japan. Expected regime change after 50 years of LDP rule is not necessary a plus. Gridlock and impotence could be the result. No clear reason Japan will benefit from improved China-Taiwan relations eithers. (Japanese themselves seem to think this is very bad for THEM)

Investors pass over Japan for just about any other Asian markets for very good reasons. Koreans are catching up fast. China's nominal GDP will pass over Japan within 2 years, maybe by the end of THIS year. China's stock market valuations (Ex HK) exceeded Japan's once again and may never look back.

The Yen carry trade seems to have resumed, money flow may once again be toward the exit. There are just not much catalyst and relative low valuation seem justifiable.

Jul 23 03:19 PM

[Mad Hedge F...:]

Just to consider every side. Japanese Prime Minister Taro Aso’s call for national elections on August 30 is setting up a potential “black swan” type event. His Liberal Democratic Party (LDP) has ruled for all but 11 months of the past 55 years. But his party’s 18 year effort to spend itself out of an “L” shaped recovery has failed miserably, succeeding only in converting Japan from the least, to the most indebted industrialized country. Think of a 1,000 “bridges to nowhere.” So the opposition Democratic Party of Japan (DPJ) has a real shot here, which has promised to fundamentally remake the economy by boosting social spending, canceling useless construction projects, and encouraging domestic consumption. Remember what a surprise Congress Party win did for India’s stock market? Look at the excellent piece from The Permanent Wealth Investor’s Martin Hutchinson for an analysis of how such an outcome could affect Japan on a stock by stock basis at www.moneymorning.com/2.../

Jul 23 06:46 PM