By Nicholas Vardy
After spending almost two decades in global investors' dog house, Japan has become the hottest major stock market on the planet. Tokyo's benchmark Nikkei index has surged 34.5% since mid-November to mark its longest winning streak since Japan's 1980s "bubble economy."
Japan is now the world's best-performing major stock market over the past three months. By way of comparison, the S&P500 has gained only 11.2% over the same period.
So what's behind the big change in sentiment about Japan's stock market?
Expectations are that economic reforms by Japan's new Prime Minister Shinzo Abe will help wake the Japanese economy from its 20-year slumber. And corporate profits of major exporters in Japan are set to soar thanks to the systematic weakening of the yen.
"Regime Change" in Japan
Since its financial bubble burst over 20 years ago, Japan has gone from the United States' #1 economic rival in the 1980s to an economic also-ran. Both the government and the Bank of Japan's (BoJ) efforts to jump-start Japan's flagging economy have consistently fallen short. As a result, despite occasional rallies, including a 40% rise in 2005, the Japanese stock market's weighting in global investors' portfolios has dwindled from about a third to a mere 8%.
Among investors, Japan is like the "boy who cried wolf." Japanese officials have shouted "economic revival" so many times -- and have disappointed each time -- that it's no surprise that it takes a lot to grab investors' attention.
But somehow Japanese Prime Minister Shinzo Abe has managed to do just that.
After winning election for the second time in December 2012, Abe called for a "regime change" at the Bank of Japan (BoJ) -- in the form of a new Central Bank governor who would lead a bold easing of monetary policy. And so far, he is getting what he wants.
On Feb. 5, Masaaki Shirakawa, the BoJ's governor, announced his decision to step down three weeks before his term was to end on March 19. The very next day, the Nikkei stock index closed at its highest level since October 2008 and the yen fell to a 33-month low. Last week, Mr. Abe nominated Iwata, who currently is a professor at Tokyo's Gakushuin University, to be the new deputy governor of Japan's central bank. Iwata has publicly supported a more aggressive monetary policy to end nearly two decades of deflation and economic stagnation.
Catalyst for the Market: The Falling Yen...
The main catalyst for the recent rally in the Japanese market has been the weakening yen. As you can see that from the chart of the CurrencyShares Japanese Yen Trust (FXY), the yen has been a one-way bet over the past three months.
The weaker yen makes Japanese exports more competitive and boosts earnings from overseas for the household names among Japanese corporate giants. According to Japan's Ministry of Economy, Trade and Industry, the break-even exchange rate for Japanese exporters is about 85 yen to the dollar. Goldman Sachs estimates that for every 10 yen the currency weakens against the dollar, profits of exporters would rise by 7% to 10%. With the yen already trading at about 93 to the dollar, after a devaluation of 14%, profits to Japanese companies are set to soar.
So, just how low can the yen go? Consensus estimates are that the yen will fall to 100 yen against the dollar this year.
Others believe that the bottom is set to fall out from under the yen. Market maven Dennis Gartman believes shorting the yen is "the trade of the next 10 years."
The #1 Way to Profit from Japan's Rally
Although the Japanese market has already rallied by a third in yen terms, I believe the Japanese market could rally another 40% this year.
Here's why. In terms of stock ownership, Japan is all about foreign investors, who make up about 70% of the trade volume. At the same time, most investors are underweighting holdings in Japan. So, as more and more investors increase their allocation to Japan, I believe you will see the market continue to rally.
In my investment newsletter, The Alpha Investor Letter, I originally recommended Japan, through the WisdomTree Japan SmallCap Dividend (DFJ), because Japanese small caps were the cheapest asset class in the world.
And indeed, DFJ has rallied 13% since November 14, 2012.
The real frustration has been that, thanks to the weakening yen, the rally in Japanese stocks has not translated into even bigger U.S. dollar gains.
And with the government (and now the BoJ) committed to devaluing the yen, you need a way to hedge against the declining yen so those gains can translate directly into U.S. dollar terms.
The solution? The WisdomTree Japan Hedged Equity Fund (DXJ). As the name suggests, this ETF hedges its exposure to the yen, while investing in some of Japan's largest exporters.
Just compare the performance of the hedged WisdomTree Japan Hedged Equity Fund (DXJ) versus the unhedged iShares MSCI Japan Index (EWJ) over the past three months.
No wonder DXJ has reeled in over $2.6 billion so far this year, including an inflow of $386.7 million just last week.
So, you may want to follow the recommendation I made to my Alpha Investor Letter subscribers last month, and buy the WisdomTree Japan Hedged Equity Fund (DXJ) at market today. Place your stop at $37.00.
To keep up on the latest investment activities, check out Eagle Daily Investor, where my e-letter appears each week. To read my e-letter from last week, please click here. I also invite you to comment about my columns, as well as the articles and columns of the other Eagle Daily Investor writers.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.