Why Japanese Stocks Are Poised For A Breakout

| About: WisdomTree Japan (DXJ)

Summary

Fundamentals continue to be healthy with latest Manufacturing PMI in solid growth territory.

Japanese stocks' valuation remains cheap relative to its G-7 peers based on the price-to-book ratio.

Technicals point to yen resuming lower which will be supportive for Japanese stocks.

Stars are aligned for Japanese stock market to breakout to the upside from its multi-month consolidation.

Heading into the Golden Week holidays, the Japanese stock market (NYSEARCA:DXJ) had the sharpest two week gain since the Trump rally at the end of latest year, as the DXJ launched an impressive 8% off its lows in mid-April in a classic V-shape recovery. Signs are suggesting that this is just the beginning of a bullish breakout heading into the second half of 2017.

Fundamentally, the most recent manufacturing PMI continues to be in solid growth territory at 52.7. Per Nikkei Asian Review:

Growth of the Japanese manufacturing sector is being sustained at a healthy clip at the start of the second quarter, with the data remaining consistent with underlying rises in official production of around the 2% mark,

As shown below, the year-over-year performance in the Nikkei 225 has a high correlation with the year-over-year change in the manufacturing PMI, which is in the midst of the strongest uptrend since 2013. We expect the uptrend to continue, leading into solid gains in the Japanese equity market.

Japan Manufacturing PMI YoY vs. Nikkei 225 YoY

(Source: Investing.com)

Japanese stocks are also cheap from a valuation perspective relative to its G-7 peers. Using DXJ as the benchmark for Japan, the weighted average price-to-book ratio of the underlying holdings is subdued at 1.20, comparing to the S&P 500's (NYSEARCA:SPY) of 3.0, which is the highest among the group. Obviously, the market and corporate fundamentals are very much different which justify the wide differential. A better comparison takes into account of the corporate profitability. As such, we plot the weighted median return-on-equity (ROE) vs. price-to-book (P/B) to gauge the relative value between the country ETFs.

Country Benchmark Weighted Average Price to Book Ratio Weighted Median ROE
Japan DXJ 1.20 8.88%
United States SPY 3.00 21.34%
Canada EWC 1.98 11.95%
Germany EWG 1.71 13.19%
Italy EWI 1.11 6.29%
France EWQ 1.56 11.54%
United Kingdom EWU 1.82 16.81%

G7 ROE vs P/B

Clearly, there is a positive relationship between the ROE and P/B ratio - the higher the ROE, the higher the justified P/B ratio is. Next we determine the fair P/B ratio relative to the rest of the group based on the results of the linear regression (dotted line). For the DXJ, the fair P/B is 1.30, which is 8% higher than the prevailing P/B of 1.20, suggesting DXJ is cheap on a relative basis.

Meanwhile, the technical picture of the yen (NYSEARCA:FXY) also supports the bullish case on Japanese stocks. On the heels of geopolitical uncertainty and short covering, the yen had strengthened substantially, notably with the USD/JPY crumbling under 110 handle, which contributed to the sharp decline in Japanese stocks. However, with the net short speculative positioning in Japanese yen futures shrinking to lowest since late 2016, our view is that the yen will resume decline with the USD/JPY headed for the YTD high of 118.

Yen Futures vs. Spec Positioning

(Source: Finviz)

Looking at the DXJ chart, according to WingCharts, while the short-term technical picture is overbought after the sharp V-shape recovery, the technicals in the longer-term weekly chart suggests 67% chance of more upside ahead in the next 20 weeks:

(Source: WingCharts.com)

DXJ has been one of our core long positions since April in our Quant ETF portfolio, and we envision staying long in the medium-term based on the favorable fundamental, valuation and technical factors discussed above. We advise buying dips into any short-term pullback with a target of 56, which is the 2015 post-crisis highs.

Disclosure: I am/we are long DXJ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.