Why Japan Stocks Will Lag In 2013: S&P Capital IQ

Japan's stocks fell for a fourth day straight Tuesday as the yen strengthened against most major currencies, cutting the earnings forecasts for exporters.

IShares MSCI Japan Index ( EWJ ), the most popular ETF tracking the island nation, gave back 1.48% to 9.63.

That's while the iShares MSCI EAFE Index ( EFA ), tracking developed foreign markets, skidded 0.68% to 56.83.

SPDR S&P 500 ( SPY ) let up 0.47% to 145.29.

iShares MSCI Emerging Markets Index ( EEM ) dropped 1.05% to 44.18.

EWJ is trading high above its 50- and 200-day moving averages, indicating it remains in a solid uptrend. Declines the past four days so far can be considered a normal pullback in an uptrend. It has performed on par with EFA recently, gaining 5.32% in the past month and 7.67% the past three months vs. 4.11% and 5.98% for EFA over those periods. Japan has lagged global markets in all time periods, including its mere 0.9% return for the past 15 years.

EWJ carries an IBD Relative Strength Rating of 51, which means it's outpacing half the market and underforming half. It has a strong IBD Accumulation-Distribution Rating of B+, suggesting institutions are buying considerably more shares than selling.

Japan stock funds, which posted their biggest annual inflow last year since 2005, absorbed $474 million the first week of the year, according to EPFR Global.

CurrencyShares Japanese Yen Trust ( FXY ), measuring the yen against the dollar, gapped up 0.64% to 112.47. FXY collapsed 10% over the past three months as Japan's new government embarked on a course to debase the currency to boost exports. The inflationary policy is aimed at lower borrowing costs.

On Tuesday, FXY appeared to be staging an oversold bounce off of a 2-1/2-year low. A strong currency reduces the value of the foreign earnings for Japanese exports.

Alec Young, global equity strategist at S&P Capital IQ, sees clouds forming over the land of the rising sun and recommends investors should sell out of Japanese stocks.

Young wrote in a report released Tuesday:

"The island nation's export reliance gives it above-average currency sensitivity, with every shift in the yen's value having an above-average impact on this influential equity market's performance. The daily correlation between Japanese equities and the dollar-yen exchange rate is 87%. This stems from large export manufacturers in the IT, industrials and consumer discretionary sectors comprising roughly half of Japan's total equity market cap.

"When the yen is strong, U.S. dollar returns are boosted by positive currency translation only to see it eroded by poor underlying equity performance in the face of a weakened export outlook. Conversely, a weak yen tends to drive above-average equity gains as export prospects brighten, only to have negative currency translation dilute dollar-denominated Japanese equity performance. U.S. investor returns suffer when overseas currencies fall vs. the greenback.

"While Japanese equities are up a strong 21.7% in local currency terms over the past 12 months, as a result of the 14.4% decline in the yen-dollar exchange rate, Japanese stocks are up only 7% in U.S. dollar terms, badly lagging mid-teens percentage gains in the U.S. and elsewhere.

"As a result of this frustrating 'catch 22' currency dynamic, our analysis indicates it's difficult for USD denominated Japanese equity performance to outperform regardless of the yen's direction."

What's more Young contends Japan's stocks are overvalued.

"At 15 times 2013 consensus estimated earnings per share, Japan trades at a significant premium to the U.S., Europe and emerging markets. In addition, its 2.1% dividend yield makes it one of only a few foreign markets to yield less than the S&P 500, undermining its total return prospects."

Young concluded:

"We expect Japan to underperform again in 2013 as increasing government fiscal stimulus, Bank of Japan quantitative easing and increased investor risk appetite stemming from improving global growth serve to weaken the yen's safe haven appeal, diluting U.S. dollar-denominated Japanese performance.

"Unfortunately for U.S. investors, even if the yen's recent weakness reverses we believe they would simply be trading currency translation pressure for renewed export jitters as a stronger yen threatens overseas appetites for Japanese goods. Either way, dollar denominated Japanese equity performance seems destined for another challenging year."

Follow Trang Ho on Twitter @TrangHoETFs .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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