DXJ: Should You Consider Hedged Japanese Stocks?

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We’re in a stock market correction, and it’s not pretty out there. The S&P 500 is down 7% year-to-date and down about 10% from its recent highs. But overseas, the carnage is worse. Most European markets are deep in correction, and the Shanghai Composite is down almost 40% from its recent highs.

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Japanese stocks have taken their lumps as well. The Nikkei index is down about 16% from its 52-week highs, and the Wisdom Tree Japan Hedged Equity ETF (DXJ) is down about 20%.

Today’s we’re going to take a look at the Japan stock market to see if there is any value to be found. And to mitigate our exposure to the Japanese yen, we’re going to focus specifically on DXJ, which strips out currency movements.

The Good Side of DXJ

I’ll start with the bullish side. With the U.S. Federal Reserve (in theory) looking to raise interest rates in the months ahead, the center of monetary stimulus has shifted overseas. The European Central Bank is experimenting with negative interest rates and a modest quantitative easing program. But the Bank of Japan has really taken monetary stimulus to a whole new level.

The Bank of Japan is snapping up assets at an annualized rate of 80 trillion yen per year. That amounts to $668 billion when translated into dollars. But remember, Japan’s economy is only about a quarter the size of the U.S. economy. So, adjusting for the smaller size of the Japanese economy, that $668 billion would be like would be the equivalent of about $2.6 trillion in the U.S. … per year!

That’s a lot of monetary stimulus, to say the least, and a lot of those yen are flowing into the Japan stock market. The Bank of Japan is dumping over 3 trillion yen per year into Japanese stocks and REITs.

This is where the DXJ story gets interesting. All of that monetary stimulus is great for Japanese stocks. But it’s terrible for the Japanese yen. Though the yen has rallied modestly during the recent market volatility, it has been in freefall for the better part of four years. So whatever gains you might have enjoyed in Japanese stocks gets thrown out the window when translated into dollars.

That is … unless you hedge.

DXJ hedges its exposure to the yen, giving U.S. investors a return close to what Japanese investors would be getting at home.

That’s the upside. What about the downside?

Why DXJ Isn’t a Good Buy

To start, there is macro risk. Japan’s national debt has ballooned to 230% of GDP, and Standard & Poor’s recently cut Japan’s credit rating to A+, putting it at the same level as Bermuda or Slovakia. If the ratings agencies were really doing their jobs, Japan would be rated as a junk credit by now. Given its aging and shrinking population and its stagnant economy, Japan’s national debt is unpayable.

Prime Minister Shinzo Abe recently announced a new set of Abenomics policies with three arrows in the quiver. Abe promises a strong economy, better child support for families, and better social security for the elderly. How, exactly, more social spending is going to be affordable given Japan’s debt load is a problem Mr. Abe did not address.

And then there is market valuation. Despite spending most of the past two decades in a bear market, the Japan stock market is not particularly cheap. Japanese stocks trade at a cyclically-adjusted price/earnings ratio of 28, putting them about on par with American stocks.

Japan’s macro risks and high market valuations make DXJ a questionable long-term bet. I think you can make a strong case for removing Japanese stocks entirely from your long-term allocation. But as a short-term trade, DXJ might have potential.

With the Bank of Japan flooding the market with yen, DXJ will probably get its mojo back and finish the year strong. So by all means, trade it to your heart’s content. Just don’t fall in love with it.

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/09/dxj-consider-hedged-japanese-stocks/.

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