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Japanese stocks have had a great December. The big economic data releases and BoJ rate meeting are history. All that's left is to coast into the New Year.

The first half of this article discusses the Japanese market and economy with no reference to specific stocks. If you want to jump ahead to my stocks and options plays, scroll down, or search for the stock tickers related to this post.

Nikkei 225 & TOPIX Performance

The Nikkei 225 maintained the 17,000 level today, adding 36.79 (0.22%) to close at 17,047.83. It is trading at its highest levels since May 9th, and about 3% away from both a multi-year intra-day and closing high of 17,563.37 established on April 7th.

The broader TOPIX gained 4.29 (0.26%) to close at 1,671.30. It is trading at its highest levels since May 16th, and about 6.5% off its multi-year intra-day and closing high of 1,783.72 achieved also on April 7th. The larger difference from its high, compared to the N225, has to do with the weighting of the index and its larger exposure to financial stocks, which have underperformed the broader market year-to-date.

Small Caps

Smaller cap stocks continue to lag. There was an article by Bloomberg this past Monday, which asked whether weakness in Japan small caps was a danger sign for global small caps, which have outperformed their larger cap rivals in the U.S. and E.U. I don't really see the global connection, especially when considering a corporate scandal in Japan that sent the market into a sell-off, which has had a prolonged negative effect on small caps, among other things, such as a weak yen, which attracts buyers to blue-chip exporters.

I actually think there's a lot of value in Japanese small caps, which continue to be difficult to play, although there are some new ETFs: WisdomTree Japan SmallCap Dividend (NYSEARCA:DFJ) and streetTRACKS Russell/Nomura Small Cap Japan (NYSEARCA:JSC) and the CEF: Japan Smaller Cap Fund (NYSE:JOF). Note I've seen JSC trade at a slight premium to its NAV and the bid-ask is often quite wide. Also, according to the Closed End Fund Association, JOF is trading at about 9% premium to its NAV.

Brief Year-end and 2007 Outlook

There are going to be a number of holidays coming up in which the Tokyo Stock Exchange will either be closed, or be on a half-day schedule. I'll publish a list of these dates soon.

Based on the recent N225 rise, and considering it is now trading well above its 2005 close, I expect Japanese stocks to mostly coast into the New Year. I don't expect a finish of less than 16,500, and would be surprised if the N225 ends above 17,500. If the N225 holds 17,000 and the TOPIX reaches and holds 1,700, I think that does much for Japanese investors after a choppy year with a lot of uncertainties over monetary policy and a few high-profile scandals.

From what I've seen published in both the U.S. and Japanese business press, analysts and strategists are overwhelmingly bullish on Japan in '07. One of the key arguments in favor of Japanese stocks, even over high flying emerging market stocks in Asia, is the quality, transparency and depth of the market -- some things which could be lacking with some of those high flyers. There are numerous other arguments that paint an optimistic outlook in '07 for Japan. On the contrary, growing concern over weak consumer spending is probably the single biggest concern for an end to Japan's longest period of economic growth post WWII. Another top concern is the health of the U.S. economy and whether there will be a soft landing.

Japanese Consumers cont.

Regarding consumer spending in Japan, I find shortcomings in the data. My biggest gripe is there appears to be an omission of spending that takes place online and on services. Japanese are big spenders online with consumption in the latest quarter reportedly nearly equaling the revenues at the nation's fourth largest department store chain. Furthermore, Starbucks announced recently it was raising prices in Japan, as both the overall economy and its earnings continue to improve.

Obviously the big damper on consumption, and also resulting in a lack of inflation growth, are the rapidly falling prices in electronics, specifically in plasma and LCD TVs. Another question is exactly how much demand there is in Japan, where homes and apartments are smaller than in the U.S., for ever-larger TVs. Thus, market participants in Japan (and elsewhere) are closely watching U.S. consumers and the economy.

Now, here's how I am playing Japan and Japan-related stocks.

First, I am buying iShares MSCI Japan Index ETF (NYSEARCA:EWJ) call options. The reversal in the yen has meant U.S. investors once again are missing out on a Japan rally. The MSCI Japan Index has gained 4.3% month-to-date in local currency, but is up only 1.9% in US$. EWJ is currently trading around $14.15, compared to its 52-week and multi-year high of $15.55 reached in May. That's a 10% difference, but the difference between current levels of the N225 and TOPIX with their highs earlier this year are 3% and 6.5%, respectively. I have positions in various January and March EWJ options contracts. See a one year chart of EWJ below.

Click to enlarge chart

iSharesJapan-EWJ-1yr-chart-12-21-06

Second, I am looking to add to my position in Internet Initiative Japan (NASDAQ:IIJI). I believe its lack of analyst coverage in Japan, and a failure to understand the importance of its business and positioning makes its shares undervalued (not to mention its president recently announced target growth of 15% and a possibility of a dividend) and represents a great opportunity at these price levels. IIJ has pulled back after transferring its listing from the Tokyo Stock Exchange's MOTHERS market to the TOPIX 1st Section. I don't think it trades too much lower and can't imagine it trading below an ADR equivalent of $8, which would mean a complete reversal. In fact, even if there's news of a secondary offering, which would likely be accompanied by a share split, I don't think that puts any selling pressure on IIJ. It has such few shares outstanding and with a good chunk of its shares owned by entities of NTT and trading companies, it means there'd be a larger float for both institutional and individual investors. I wouldn't be surprised if NTT makes an offer to acquire the firm. See a one year chart of IIJ below.

Click to enlarge chart

InternetInitiative-IIJI-1yr-chart-12-21-06

Third, I am also looking to add to my position in NIS Group (NIS). I think there's a big misconception over its business and its actually limited exposure to a government crackdown on consumer lending interest rates. The one big question is why all the stock splits. Everyone loved this stock a year ago, and now it's almost like it doesn't exist, except among Japanese day traders. See a one year chart of NIS below.

Click to enlarge chart

NIS-1yr-chart-12-21-06

Fourth, I am buying various Affymetrix (NASDAQ:AFFX) call options, with a focus on out-of-the-money, long-term contracts. One thing that compelled me to buy calls was a recent article in the Nikkei Shimbun. Another catalyst was the fact that the stock continues to be punished and trade at significantly lower levels than earlier this year (granted a recent sudden departure by its CFO is worrisome), despite its market leadership and high-growth market potential.

The Nikkei article was about Affy entering an agreement with Sysmex (Tokyo: 6869) -- the leading Japanese company (and a top global player) in medical diagnostics equipment -- for the latter to develop its technology and distribute its products in Japan and other Asian countries. Also, some data was provided estimating the current market value of DNA chips used in research in Japan to be ¥5 billion ($42m) with the market expected to grow to ¥100 billion ($847m) over about the next ten years, as the chips are rolled out for use in patient care facilities. The growth potential has attracted bigger names like Canon (NYSE:CAJ), Toray (OTCPK:TRYIY) and Toshiba (OTCPK:TOSBF).

Also, Affymetrix and rival Illumina were covered in an article in today's WSJ, which contained an important quote of Boston University's chief of genotyping, who said:

"If you cut price in half I may end up doing more than twice as many experiments."

This is important, because even though it looks like there's a price war, it might actually result in more usage and thus, sales volume. Switching costs, by the way, are high due to the initial costs of equipment. With Affy's market cap at $1.6b and what appears to be a pretty decent balance sheet, it makes me think it could be a takeover candidate given its leading installed-base and the market's growth potential. See a one year chart of Affy below.

Click to enlarge chart

Affymetrix-AFFX-1yr-chart-12-21-06

My last play heading into '07 is Raytheon (NYSE:RTN). I am also buying call options here, focusing on May '07 and beyond. Its stock has been on a very nice run, but I think there's more room to the upside. The main catalyst here for me to buy calls was a piece of news, which was given very little coverage outside of Japan, but has huge implications. In a nut shell, Japan's Defense Agency is set to become a ministry next year with autonomy over its budget.

And just out today is this seemingly negative, but actually very positive news regarding Japan's draft defense budget for next year, published by the IHT/Reuters:

Money for ballistic missile defense systems will increase by 30.5 percent from the current year to ¥182.6 billion because of a rising threat from North Korea, a Finance Ministry official said.

So, although the article mentions Japan's defense budget will decrease by 0.3% next year, it's clear where the focus is. Japan's fiscal year begins on April 1. See a one year chart of Raytheon below.

Click to enlarge chart

Raytheon-RTN-1yr-chart-12-21-06

Disclosure: I own iShares Japan, Affymetrix and Raytheon call options and I own long positions in IIJ and NIS Group.

Source: A Look at Japan and What I'm Buying