Although the Nikkei-index (NKY) is under some pressure lately, Japan's most distinguished stock market index has had a pretty incredible run over the last nine months. Since the start of last October the Nikkei has risen by a whopping 57%, outpacing all of its relevant peers by a mile. For example, the MSCI World Index did 40% less, returning 'only' 17% since October 2012.
That outperformance is, of course, measured in local currencies. Over the same period the yen, FXY, has lost roughly 25% of its value. It is exactly this massive weakening of the yen that made investors in Japanese equities so bullish. As can be derived from the graph below, the developments of the yen and of the relative performance of the Nikkei vs the MSCI World have been very closely correlated. The intuition behind this is that a strong devaluation of the yen will improve the competitiveness of the export-driven Japanese corporate sector, resulting in more sales and earnings growth from overseas and higher equity prices. Although, I agree with the mechanics of this relationship, there are a couple of things I would like to point out before jumping on the bandwagon.
Nikkei-yen relationship not always so strong
The first point is that the relationship between the yen and the relative performance of the Nikkei has not always been this strong. The graph below shows the rolling correlation between monthly changes in the USD/JPY exchange rate and the relative performance of the Nikkei vs the MSCI World since the early 1990s. The main takeaway from this graph is that only in recent years this relationship was so outspoken. Only in the last five years or so has a weaker yen (higher USD/JPY) been accompanied by an outperformance of the Japanese stock market. Before that the relationship was far less pronounced, and, in the early 1990s it was negative even.
The second point I would like to make is also related to the correlation between the yen and Nikkei. The previous graph shows the relationship between simultaneous movements in the USD/JPY exchange rate and the relative performance of the Nikkei. So, the correlation between the change in the yen in one month and the Nikkei vs the MSCI World index in that same month. Therefore, this relationship should not be granted with any forecasting power.
Yet, some investors seem to do exactly this. They anticipate that a weaker yen will lead to an outperformance going forward. But this is difficult to prove. In the next graph I have again plotted correlation data, but now between the change in the USD/JPY exchange rate in one month and the relative performance of the Nikkei in the next month. This is an easy way of examining if there is any forward looking relationship. But, as the graph shows, the correlation is very muted. On average it's about zero, +0.3 at best, telling that there is hardly any relationship between changes in the yen in the current months and the relative performance of Japanese equities one month later.
Now, a good argument to anticipate a forward looking relationship is that it takes time for the lower yen to come through in the sales and earnings numbers because of fixed contracts and so on. But, if I look at the relationship between, for instance, the change in the yen over the past six months and the relative performance of the Nikkei in the coming six months (so a time lag of six months), there is again no statistical backing. The correlation is by no means constant, oscillating between positive and negative, averaging almost zero since the early 1990s. To sum up, the relationship between the yen and Nikkei seems to be coincident, not leading.
Don't forget Risk
Finally, my last point is a familiar one, but therefore not less relevant. It's about risk. A further weakening yen, which could very well be the case, given the enormous amount of quantitative easing that the Bank of Japan is willing to execute, makes a good case for investing in the Nikkei. However, risk should also be taken into account. In recent month both the currency and equity risk in Japan have spiked. The volatility of the Nikkei has reached 25%, almost 2.5 times that of the MSCI World index. Just to keep in mind.
Although it may feel tempting to get into the Japanese equity market, be sure to do so for the right reasons. If you are taking the yen into account, which is probably a wise thing to do given the current strong relationship between changes in the yen and the relative performance of the Nikkei, determine if you are convinced enough that the currency will weaken further. Because a weaker yen now, does not necessarily leads to an outperformance of the Nikkei in the future. Also, keep an eye on the relationship over time, since it has not always been so strong, and on the additional risk that goes along with an investment in Japanese equities.
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. I have no business relationship with any company whose stock is mentioned in this article.