Japan is Cheap, But Watch The Yen

It has been a familiar battle cry for Japan bulls for what feels like ages now: Japanese equities are cheap on a valuation basis. The first problem is, due to unfavorable demographics and a severe bout with deflation, Japanese equities have been in a bear market for well over two decades. The second problem has been the soaring yen, which punished Japanese exporters.

"The last five years have been especially difficultfrom the global recession and financial crisis to the earthquake and tsunami of 2010and were compounded by an ever-rising yen that made Japanese exports less competitive in the global marketplace," WisdomTree Research Director Jeremy Schwartz said in a recent note.

Over those five years, the iShares MSCI Japan Index Fund (NYSE:EWJ), the largest Japan ETF by assets, has lost nearly 34 percent of its value. As measured by ETFs, Japanese equities have had almost perfect inverse correlation to the yen. Over the past five years, the CurrencyShares Japanese Yen Trust (NYSE:FXY) has jumped 33.5 percent.

Still, there is a value case that can be made for Japan, the world's third-largest economy. Of course, the yen will play a part in any scenario involving the Japanese economy, good or bad, but there were some positive signs earlier this year.

"As one piece of highly anecdotal evidence, just look at the first quarter of 2012when the yen weakened 7% and Japan was the best-performing country in the developed world markets," Schwartz noted.

In the past three months, FXY has lost more than four percent as traders have begun pricing in a victory for Shinzo Abe and his Liberal Democratic Party in Japan's December 16 elections. Abe, himself a former prime minister, has adopted a simple campaign platform. Much as U.S. politician would run for president pledging to reduce taxes, Abe has vowed to weaken the yen.

After a third round of quantitative easing was announced by the Federal Reserve earlier this year, some U.S. investors joked about "QE-ever." Japan could really go down that path as Abe's political talk has included terms such as "unlimited monetary easing." That explains why the ProShares UltraShort Yen (NYSE:YCS), a double-leveraged inverse play on the yen, has rallied three percent in the past month.

"Many of the nation's exporters have started to see their stocks react very positively on speculation that the yen's very outsized strength over the past five years may be set to reverse course with an Abe victory in the December 16 election," said Schwartz.

Investors looking to participate in Japan's upside while reducing potential yen-induced headaches should consider the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). December marks the first month that DXJ's index will trade with a geographic filter to remove companies that derive the bulk of their revenue from Japan.

The index also now caps sector weights at 25 percent. Industrial names currently represent over 24 percent of DXJ's weight while discretionary, technology, health care and materials names also garner double-digit allocation.

As a way of trimming yen exposure, DXJ has proven even more profitable than YCS as the former has surged four percent in the past month. Investors are taking notice. DXJ had $516 million in assets under management as of mid-November. The ETF started trading today with nearly $648 million, according to WisdomTree data.

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