Japan ETFs: Consider Fundamentals Before Bailing

Perhaps Japanese stocks and the corresponding ETFs had things too good and too easy to start 2013. The abridged version of the story goes like this: Prime Minister Shinzo Abe garnered more confidence among average Japanese citizens than his recent predecessors, the yen tumbled against the U.S. dollar to levels not seen in several years and Japanese stocks responded by becoming Asia's best performers this year.

No Day At The Beach
Then came Thursday, a day that saw Japanese stocks suffer their worst one day performance in more than two years. Friday's Asian session was no day at the beach, either. The Nikkei 225 started the day in fine fashion only to careen down to 14,000, before rebounding by more than 600 points. Days like Thursday and Friday are enough to make participants question the veracity of Japan's rally and some analysts have done just that.

This may be a 'blood-on-the-streets' scenario where cooler heads eventually prevail, particularly if the USD/JPY continues to rise.

Key Variable
"With the equity market rising in conjunction with earnings expectations, I believe the case for Japan's equity markets is intact," said WisdomTree Research Director Jeremy Schwartz in a note. "A key variable to watch, of course, is the exchange rate, as much of the moves higher in equities are tied to weakness in the yen. From a historical perspective, I believe there is more room for weakness."

Worst-Performing Currency
The yen is the worst-performing developed market currency in the world this year, a plunge that has bolstered the fortunes of ETFs such as the WisdomTree Japan Hedged Equity Fund (DXJ), the iShares MSCI Japan Index Fund (EWJ) and a swath of unheralded small-cap funds.

However, that does not mean there is not more downside in store for the yen. Currently trading in the 100-101 after recently touching 103, it is worth remembering the pair flirted with the level exactly six years ago.

"Although the yen has weakened substantially against the U.S. dollar and the TOPIX has surged, both are below their pre-crisis levels. The yen would need to depreciate another 22%, and the TOPIX would have to appreciate over 52% for them to return to the highs set in 2007," said Schwartz. "To put this in perspective, the S&P 500 is currently around 4% above its 2007 high."

Investors looking for exposure to the TOPIX can consider the iShares S&P/TOPIX 150 Index Fund (ITF), which has tumbled 6.6 percent in the past week. The often-overlooked Japan ETF is still up 13.6 percent this year.

Corporate Earnings
Underscoring the still-solid fundamental case for Japan ETFs is rising corporate earning due to the weaker yen. DXJ in particular is designed to benefit from that trend. While investors are infatuated with the ETF's short yen mechanism, they overlook DXJ's explicit focus on Japanese exporters.

"The products that Japanese companies sell worldwide become cheaper to foreign buyers as the yen weakens against their domestic currencies," said Schwartz. As these products become relatively cheaper across the globe, the demand increases, allowing Japanese companies to sell more. The companies eventually must bring the money back to Japan, and when they do, they are able to exchange the foreign currencies against more yen. This process has allowed many Japanese companies to report increases in sales and profits."