Dollar Reverses Course Against Yen, Japanese Stocks Jump, ADRs Seen Flat

Includes: EWJ, IIJI, JPXN, NIS
by: Steven Towns

The foreign exchange markets are known for their volatility. But with everyone jumping on the weak dollar bandwagon, who would have expected a reversal against the yen in a matter of one week?

For some interesting discussion of the yen, dollar and Nikkei, see Gary Dorsch's "Japan's Nikkei-225 and the Dollar/Yen Dance."

In the past five trading days the dollar has effectively appreciated about 2% against the yen, which is the equivalent of a linebacker chasing down a running back just as he's about to break out for a long run down the sideline. See a five day chart of the US$/¥ below

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Japanese stocks have been on a nice rally of late (the Nikkei 225 added another 0.70% today) despite concerns of a weakening U.S. economy, and Japan's own weaker-than-expected economic data. Still, I commented before on the resiliency of Japanese exporter stocks as the dollar was strengthening. Now, everyone seems to be plowing money into them. See a one month chart of the N225 and S&P 500 below.

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A number of market analysts in Japan say they have seen a recent up-tick in foreign brokerage buy orders. It could be the case that foreign investment capital is supporting this latest rally. I've commented before that Japan has mostly underperformed global markets year-to-date, and thus, the value case is in play again as earnings growth remains strong and the Japanese equity market offers both depth and quality.

John Bethel of Controlled recently posted about a WSJ article covering UBS' bullishness on Japan, in which the firm's global head of M&A commented as follows:

"We want to maintain our market leadership in Japan and Asia. Japan is a market where we want to expand."

"We are very bullish on Japan ... (For M&A,) it could be the fastest-growing market in the world" in three to five years."

A stronger dollar is a double-edged sword for American investors in Japanese ADRs, ETFs and other funds. Exporter stocks will gain favor but share price gains will be capped. My thinking all along (and still now) is the yen will eventually (by the end of '07) strengthen against the dollar on a sustained basis, and we'll see rates fluctuating between ¥105-¥110 per dollar, as opposed to ¥115-¥120. That means there could be a nearly 10% appreciation in Japanese ADRs and funds based on currency alone. However, don't get too excited since many large holdings are export-oriented, and would likely either be very volatile and/or not see as much share appreciation as domestic-demand stocks.

My only stake in Japan-related investments at the moment is in two smaller-cap plays, Internet Initiative Japan (NASDAQ:IIJI) and NIS Group (NIS), in addition to a broad Japan mutual fund. Both IIJI and NIS were on a nice run, but it seems a combination of uncertainty and profit taking have slowed the enthusiasm, likely only temporarily.

IIJI received big news late last week that it will be moving from the Tokyo Stock Exchange's MOTHERS market to the 1st Section of the TOPIX. For some reason there was downward pressure on its shares today in spite of IIJI commenting that it will not be issuing shares or implementing a stock split. This is supposed to be good news -- as TOPIX-related index funds should add IIJI later this week -- since it only has 204k shares outstanding. IIJI is a long-term holding for me. Lehman recently initiated coverage at "equal-weight." And I saw that Daiwa continues to give it its highest rating "1" and I believe it gave it a ¥500,000 ($10.68 ADR equiv. at ¥117/$1) target share price. It closed at ¥413,000 ($8.82 ADR equiv.) today. See IIJI's one year chart below.

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Disclosure: I own long positions in IIJI and NIS Group.