Japan?

Even after today's pullback, the Nikkei 225 Index is up over 22% since November 14, 2012. This is due in large part to the election results that brought the Liberal Democratic Party back to power. Since then Prime Minister Shinzo Abe has announced 10.3 trillion yen ($116 billion) in additional stimulus and continues to pressure the Bank of Japan to double its inflation target to 2%. Meanwhile, valuations such as price to book are significantly lower than average and earnings are expected to grow almost 50% this year.

Responding to expectations of more quantitative easing from the Bank of Japan, the yen has declined by approximately 11% over the same time period. This should be a big boost to Japan's export led economy.

In the short term, both the Nikkei and Yen appear overextended and should experience a pullback, which may have started today. While Japan faces both a large debt load and an aging population, the current combination of stimulus, expected quantitative easing, low valuations and earnings growth should allow for a further advance. The 12,000-12,300 area (or approximately 13-15% higher), would appear to be the first target.
 

However, as with all international investments you have to take into account the effect of the currency. In this case, a depreciating yen, while helping Japanese exporters, would hurt international investors as they translate their holdings back to their home currencies cancelling out some if not all of the benefit from the rising market. Therefore it is critical to hedge the currency effect away. Institutional investors can easily do this in the futures markets. Individual investors can do this by purchasing an ETF that tracks a Japanese stock index and then hedges out the currency.

Of the twelve Japanese equity ETF's I quickly found using the screener on www.etfdb.com only two indicate they are hedged, the Wisdom Tree Japan Hedged Equity Fund (DXJ) and the db-x MSCI Japan Currency Hedged Equity Fund (DBJP). Of the two, the DXJ has a lower expense ratio, more assets, and more liquidity. (Full disclosure I own DXJ ).

To illustrate the difference, below is a chart of the non-hedged iShares MSCI Japan Index ETF (EWJ). It is up 12.9% since November 14, 2012. A very nice return for two months, but below that of the Nikkei. Some of this is the difference in indexes, but the majority is due to the 11% drop in the yen.

 

For the same time frame the DXJ is up 22%, or over 9% points more. This is predominately because it has hedged out the effect of a declining yen thus enabling the foreign investor to gain the full benefit of the rising Japanese market.