The Bank of Japan’s historic monetary stimulus measures are prompting exceptional anxiety. However, whether the BOJ’s moves will accomplish their reflationary goals or have large scale unintended consequences is not the subject for this article. Instead, let’s look at the near term effects and propose a way to take advantage of it through exposure to an asset class that will likely be one of the primary beneficiaries without simultaneously suffering dilution from exposure to the yen.
Japanese Profits, in Dollars
The WisdomTree Japan Hedged Equity Fund (NYSE:DXJ) provides broad-based exposure to Japanese equities while hedging away fluctuations between the yen and U.S. dollar. In this way it seeks to track the performance of Japanese stocks in dollar terms without any interference from exchange rate variations.
This hedging aspect is important since the same stimulus that is designed to pump up Japanese asset prices will, if it does its job, have a concomitant effect in depressing the yen. As a U.S. investor in Japan’s stock market, this can turn out to be mixed bag. U.S. citizens investing directly in Japanese companies can see stellar returns evaporate when they have to re-convert profits back into their home currency.
The upside to this relationship, especially as far as DXJ is concerned, is the effect that a falling yen has on Japanese equity prices. Research shows that historically there has been a strong correlation between yen weakness and Japanese equity strength. Much of this correlation is due to Japan’s heavy reliance on exports.
Of course the hedging component of DXJ goes both ways. When the yen is getting stronger, DXJ’s returns will be muted vis-à-vis its yen-denominated ETF peers. Yet given the BOJ’s resolve to devalue the yen over the next 24 months, the current environment is likely to favor DXJ.
Other non-hedged Japanese ETFs have done well this year but appreciably less than DXJ. The iShares MSCI Japan Index Fund (NYSE:EWJ), the heavyweight ETF in the sector, has returned 12.41% YTD. Others such as the Precidian Nikkei 225 ETF (NYSE:NKY), the Japan SmallCap Dividend Fund ETF (NYSE:DFJ), the iShares S&P/TOPIX 150 Index ETF (NYSEARCA:ITF), the SPDR Russell Nomura Small Cap Japan ETF (NYSEARCA:JSC) and the iShares MSCI Japan Small Cap Index Fund ETF (NYSEARCA:SCJ) have all returned between 11% – 14% for the year. DXJ has posted a 20.7% return, the difference being attributed to hedging out the yen.
Click to EnlargeYes, this first chart looks impressive – if yen is your domestic currency. If you use dollars however, the next chart should temper your enthusiasm.
The rapidly depreciating yen has owners of non-hedged Japanese ETFs feeling like they are only getting a consolation prize.
Up 42% in 4.5 Months – Too Much Too Fast?
Getting on board DXJ right now may feel a bit like trying to jump on a Japanese bullet train clipping along at full speed. Having increased over 42% since mid November of last year, one may wonder if a pullback or at least some consolidation is in order.
Click to Enlarge The bank’s move is long term, open-ended, and paradigm-shifting. With this announcement, the trend is firmly reinstated and now making new highs. Pullbacks to the trendline will take place eventually, but it may require patience before a good entry point forms.
The BOJ’s actions, of course, are not without risk. From 2003-2007, Japan’s economy experienced a seemingly strong recovery after 12 years of deflation and virtually no growth – their infamous Lost Decade. If capital spending among Japan’s exporters is included, net exports accounted for almost half of the growth in GDP in the five years up to 2007. And while Japan did not have housing or credit bubbles like the U.S., their boom in exports was due to a very weak yen that complemented insatiable demand among US and European consumers who had easy credit at their disposal. Japan’s bubble was in their exports.
When the crisis hit, foreign demand plunged while the yen soared – and this combination caused industrial production and real GDP to collapse to an even greater degree than in other industrialized countries, revealing Japan’s twin vulnerabilities of high dependence on a cheap currency and excessive debt.
So the fact that the BOJ is doubling down on both is not without due warning. But in the short term, markets have shown that monetary stimulus is a strong catalyst.
Recommendation: Use DXJ to gain exposure to the stock-priming effects of the Bank of Japan’s new monetary stimulus measures.
Option Alternative: Buy to open the DXJ May 46 Calls for $1.45 or less. If upward momentum continues to accelerate, you may want to consider rolling that trade out into a longer expiration.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.