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2006 was nowhere near as spectacular for Japanese stocks as was 2005 -- though the last month of trading was definitely encouraging. A recap of 2006 follows as we await the first day of '07 trading in Tokyo this Thursday.

Note: Scroll to the bottom for a brief outlook for 2007.

Japan Indices 2006 Performance (year-end close and y-o-y %)

Nikkei 225: 17,225.83, +6.9%
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TOPIX 1st Section: 1,681.07, +1.9%
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JASDAQ: 86.19, -33.8%
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1-year comparison chart of N225 ['blue'], TOPIX I ['red'] and JASDAQ ['green']:
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2006 Top-5 ADRs:

1. Canon (NYSE:CAJ) +46.3%
2. Konami (NYSE:KNM) +39.8%
3. Honda (NYSE:HMC) +38.8%
4. Kyocera (NYSE:KYO) +31.0%
5. Makita (OTCPK:MKTAY) +28.5%

2006 Worst-5 ADRs:

1. NIS Group (NIS) -62.3%
2. Trend Micro (TMIC) -23.5%
3. Internet Initiative Japan (NASDAQ:IIJI) -23.4%
4. NEC (NIPNY) -21.5%
5. Nidec (NYSE:NJ) -10.1%

The average gain among the 28 ADRs I included in this analysis was 7.35%. See the chart below which shows the yearly performance of all 28.

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2006 Performance of Japan ETFs and CEFs

The results here are rather interesting because the top-two performing funds are from WisdomTree, the first which is a Small-Cap Dividend fund (NYSEARCA:DFJ) that returned 25.3%, beating the High-Yielding Equity Fund (NYSEARCA:DNL) by nearly 10% and smashing the average return of 7.1% among 9 funds I surveyed. Note: WisdomTree's funds were launched June 16. And the streetTRACKS Russell/Nomura Small Cap Japan (NYSEARCA:JSC) was launched Nov. 14.

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2006 Japan vs Asia: iShares Fund Performance

This chart contains 8 funds, one of which is iShares MSCI Japan Index (NYSEARCA:EWJ), the most actively traded country-ETF in the U.S. It also contains 6 other countries including Australia (NYSEARCA:EWA) and the Pacific ex-Japan Index (NYSEARCA:EPP). iShares Japan clearly underperformed by less than half its nearest rival, S. Korea (NYSEARCA:EWY) and less than 8x Taiwan (NYSEARCA:EWT). The Pacific ex-Japan Index outperformed EWJ by about 5x. Singapore by the way is (NYSEARCA:EWS), Malaysia (NYSEARCA:EWM) and Hong Kong (NYSEARCA:EWH). Also, FYI Vietnam and mainland China led all of Asia in '06.

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2006 Forex

The last chart is of the Japanese ¥ and US$. American investors should pay particular attention to the dollar's rally against the yen of late. As I often explain, yen weakness hurts U.S. investors in Japan ADRs and funds, even as it boosts stocks in Japan, especially exporters. Over the past month the result has been reduced gains for U.S. investors, similar to what happened in '05, but on a lesser scale. This may be a buying opportunity of sorts, especially if Japanese stocks continue to climb in '07 and if the BoJ hikes early in the year, which would boost returns.

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2007 Outlook

I don't have any specific predictions for 2007. All I can say is I was bullish in '05 and it turned out to be a very nice year. I started off very bullish in '06, but it was a bumpy ride that thankfully ended nicely. As Tokyo opens for a half-day of trading Thursday, I continue to be bullish. I like small and mid cap stocks, even though they are widely neglected. I also see upside for the banking industry, which underperformed in '06.

Blue chips and especially exporters will continue to dominate headlines and make gains as long as the yen continues to trade closer to ¥120/US$ than to ¥110/US$. I would say that I expect the Nikkei and TOPIX to outperform the S&P 500, but warn that there is always the possibility of highly correlated trading as we saw at various points in '06. That said, I expect that I will continue to play individual stocks and trade options where possible.

I won't list all the bullish and bearish factors here, but I can confidently say the former outweigh the latter. Lastly, in regard to the underperformance of Japan versus Asian emerging markets, I feel this may be a blessing, as I've said before because of quality, depth and valuations.

Disclosure: The author owns shares of IIJ and NIS Group, and iShares Japan and IIJ call options.

Source: Japan: 2006 Year in Review, 2007 Outlook