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Recent news out of Kabutocho, Japan's "Wall Street," would have you thinking Japanese stocks and the economy are doomed, again. That is not the case at all. I expect a strong year-end rally and am putting my money where my mouth is.

First, the economy has officially established a new post-WWII record for expansion, nearing its 5th year, and albeit not sizzling like it was in the 60's and early 70's, it's impressive enough considering the "lost decade" of the 90's up to 2002.

Year-to-date, the Nikkei 225 Stock Average, the Japanese benchmark index, has underperformed the S&P500 by nearly 15%. Despite reports of high correlation at various points throughout the year, the two have split and gone in separate directions as of November. Over the past two years, the N225 has outperformed the S&P500 by as much as 50%, so it makes sense that there will be periods of corrections and repositioning by investors. Increasingly, analysts point to the fast overseas money that moves Japanese stocks, and that has put downward pressure on equities in recent trading.

The biggest risk aside from geopolitics is believed to be the Japanese consumer. This is not to be taken lightly, but just as with the over-focus on lending with Japan's mega banks, I think analysts and investors alike, are not seeing the big picture. The employment conditions in Japan couldn't really be any better. I believe it's only a matter of time before companies channel more of their profits to employees and in turn, consumers start spending more. There's no time better than now to see consumers quiet the skeptics as we near the most important shopping season of the year.

Positive developments I see providing support for equities include the public's strong support of the Abe administration. Also, the government and Bank of Japan seem to be getting along better than in the past and in reality, a follow-on rate hike of 0.25% would not have all that much impact on lending (it will of course affect repayment of government debt). One area it would help is in the banking sector, although consumer finance firms will still face pressure due to the government crack down on lending rates and compensation to those who paid rates in excess of legal limits.

It goes without saying the extraordinarily low rates in Japan keep the yen weak, which means exporters continue to benefit: think how many cars and how much electronics are being sold in the U.S. and especially the EU, where the yen is trading at its weakest level all time against the euro. Foreign currency is a double-edged sword, but at this point I think there's more reward than risk, since investors are aware of the yen's weakness and it shouldn't necessarily impact exporter stocks if it strengthens against global currencies incrementally, which it is seen doing in '07 with BoJ normalization of monetary policy. U.S. investors in Japanese equities benefit from yen strength.

The recent news of a recommended end to favorable capital gains and dividend taxes was cited as being reason for heavy selling on Monday. I agree with the Tokyo Stock Exchange chief in that it is a temporary effect. A reversion of the taxes won't keep investors from playing the market, as tax rates won't be exorbitant by any means. There is also rumor of a hedge fund blow-up that has been denied by Citadel of Chicago. I am not sure exactly what this means due to conflicting reports, but I'd argue if anything, it has to do with smaller capitalization stocks.

Speaking of small-cap stocks, the value story is very compelling as selling has been relentless, in addition to the growth prospects. The problem remains that it is difficult for non-Japanese to participate in this segment. There is a new ETF by State Street Global Advisors, the StreetTracks Russell/Nomura Japan Small Cap (JSC), but unfortunately as is the case with many ETFs, the volume is very thin.

If you don't believe the prospects of Japan, just consider the fact that overseas private-equity funds have been moving in left and right and M&A remains robust. Companies are reacting by consolidating subsidiaries and in some cases there have been LBOs.

Also, quarterly earnings reports have been broadly and consistently strong throughout the year. There's a lot of cash in Japan that can be put to use. In one respect, a growing number of companies have been more active in enhancing shareholder value.

Some worry about the state of the U.S. economy, specifically consumers and housing. Japanese companies that have heavy exposure to exporting are at risk, but let's not forget that China and the Asia-Pacific region have become an increasingly important market for Japanese products and Europe is also a key end-market that is often forgotten.

Other indicators that show Japan stocks are due to rebound above and beyond today's 1.14% gain in the Nikkei include a not insignificant number of stocks trading at/near 52-week lows and rising short interest. Psychologically, it is important for the Nikkei to close above where it finished last year too.

I've recently established positions in the following Japanese stocks with an "investment" purpose: Internet Initiative Japan (IIJI), NIS Group (NIS) and Nomura Holdings (NMR). I also continue to add to my Japan mutual fund. And most importantly, I'm playing my predicted year-end rally by buying Dec/Jan call options on iShares MSCI Japan Index ETF (EWJ).

iShares MSCI Japan Index ETF (EWJ) and S&P500 Year-to-date chart:

EWJ-SP500-YTD-chart-11-21-06

Disclosure: I own positions as stated above, in Internet Initiative Japan, NIS Group, Nomura Holdings, and iShares MSCI Japan Index.

Source: Predicting a Strong Year-end Finish for Japanese Equities