3 Telltale Signs The Japan Rally May Not Be Over

| About: WisdomTree Japan (DXJ)

With U.S. stocks rallying, investors may be tempted to stick with a home country bias. Russ discusses why Japan is still worth a look.

Last year, the markets were distinguished by a lack of persistence. In many respects, investor behavior in the second half of the year was the mirror image of the first six months. However, one element remained consistent, at least among U.S. investors: a preference for domestic over international equities.

With U.S. stocks having a strong start to 2017, many are likely to remain committed to a big home country bias. I think this is a mistake. As I discussed last fall, relative performance is starting to shift. Since last summer's lows, Japanese equities are up roughly 25% in local currency terms. Europe is up over 20% (gains are lower in dollar terms). Going forward, I still believe that Japanese stocks in particular merit a larger allocation.

Japan still the cheapest developed market

While Japanese stocks bottomed in 2012, Japan remains reasonably priced in contrast to the U.S., just about every other developed market and even many of the emerging markets in Asia (see the accompanying chart). Other markets, notably the United States, have seen prices driven primarily by multiple expansion, i.e. paying more for a dollar of earnings, though Japan has benefited from rising earnings.

Supportive monetary policy and rising inflation

Headline inflation (measured by the Consumer Price Index) in Japan is rising at the fastest pace since early 2015. Not only is this good news for a country long mired in deflation, it is particularly important in the context of the Bank of Japan's commitment to keeping interest rates close to zero. To the extent inflation continues to rise, real interest rates (the interest rate after inflation) move deeper into negative territory, suggesting ultra-accommodative monetary conditions and a weaker yen. The latter is key for an economy geared toward global trade.

An improving corporate sector

Historically, one of the many challenges facing Japan was a relatively unprofitable corporate sector. That is in the process of changing. Improving corporate governance coupled with Japan's own buyback trend has pushed the notoriously low return-on-equity (ROE) up to around 7%. While still low by U.S. standards - partly a reflection of a multi-decade deleveraging by Japanese corporations - this is well above the 20-year average of 4%.

For U.S. investors, it is instructive to compare the bull market gains in the United States to those in Japan. Here in the U.S., the price-to-earnings (P/E) ratio on the S&P 500 Index has risen by roughly 75% since the market bottomed in 2009. In contrast, since bottoming in 2012, Japanese equity valuations are relatively flat. As a result, Japan remains a value play in an increasingly expensive world.

To be sure, there are risks. First and foremost, a thriving Japanese stock market is most likely predicated on a weaker yen. This suggests that dollar-based investors will want to at least partially hedge their foreign currency exposure.

Still, investing outside the U.S. may not seem obvious in the midst of a still strong U.S. bull market; perhaps that is exactly the time when investors should seek more diversification.

This post originally appeared on the BlackRock Blog.

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