J.D. Steinhilber, founder of ETF newsletter and investment management firm Agile Investing, explains why he's overweight Japanese stocks via the ETFs EWA and VPL:
Japan was the best performing global stock market in August, as positive economic and political developments ignited a sharp rally that lifted the benchmark Nikkei index through key resistance to its highest levels since 2001. A landslide victory by the Liberal Democratic Party in the September 11 elections gave Prime Minister Koizumi the mandate he sought to implement a program of smaller government and privatization.
Meanwhile, Japan’s economy continues to gain momentum. Japan’s annualized GDP growth in the second quarter was revised upward to 3.3%, virtually identical to the 3.4% growth rate posted by the U.S. economy in the second quarter. Our rationale for having an overweight allocation to Japan has been based on valuation, sentiment, and diversification.
As a result of a protracted economic slump and bear market dating back to 1990, Japanese stocks became attractively valued relative to other developed economies, especially the United States. Based on a composite of five fundamental valuation measures - price-to-earnings, price-to-sales, price-to-book value, price-to-cash flow, and dividend yield, Japanese stocks are 20% cheaper than their U.S. counterparts. In the past, Japan’s sluggish economy may have warranted a discounted valuation, but with GDP growth rates now close to parity, that is no longer the case. Due to its extended stock market slump and numerous false starts, sentiment has long been bearish towards Japan, and the country has been underweight in the average global equity portfolio, which is bullish from a contrarian perspective.
Lastly, among major overseas economies, the Japanese stock market has the lowest correlation to the U.S. stock market, which means it offers the greatest diversification benefits. Over the past 20 years, whereas European stocks have had a 77% correlation with U.S. stocks, Japan has mirrored the U.S. market only 42% of the time.
Another potential benefit to investors in Japanese-oriented ETFs (e.g. EWJ and VPL) is the prospect of a stronger Yen. The Yen is near the weak end of its 2-year trading range relative to the U.S. dollar. If the Yen were to move back to the top end of this range – on the basis of Japan’s strengthening economy and its trade and capital surpluses relative to the U.S. - it would represent a 9% return to a U.S. dollar-based investor, before any stock price movements are taken into account.