There is a point in Sofia Coppola’s Lost in Translation, a movie about
the disorientation and dislocation felt by a jetlagged American in a fancy Tokyo
hotel, when one can wholeheartedly sympathize with its lead character—
everything seems familiar enough, but all the cultural markers are different,
and everyday situations become strange and perplexing as a result.
Investors in iShares MSCI Japan Index Fund (AMEX: EWJ) may have felt
disoriented after January’s sell-off, which was spurred by a regulatory
investigation into the Internet company Livedoor. Given all the positive news
that had preceded the event, they must have wondered whether EWJ might be
another foreign opportunity that could get “lost in translation.” But we believe
the Japanese market may finally become easier to navigate. One aspect of our
navigational system for investing in foreign markets is momentum based on
relative strength, and we expect EWJ to rise again.
After the speculative bubble that sent Japanese equities to dizzying heights
popped in 1989, it took 14 years for the market to reach what we believe was a
secular bear market bottom. During that time, the Nikkei lost 80 percent of its
value, and in the process it wrung out each and every bullish sentiment and hung
them all out to dry. In the meantime, the extreme optimism of the 1980s was
replaced with the unprecedented pessimism and fear that come from an extended
deflationary cycle of declining equity and real estate prices.
The Nikkei 225 has already rebounded nicely from its 2003 low of 7,603. In fact,
a technical study performed by UBS Investment Research shows that the index has
accomplished a 23.6 percent Fibonacci retracement on its monthly chart,
indicating the next target level would be 19,376, or 15.6 percent above its
February 6 high. EWJ has tracked this rebound nicely, and after it broke through
its own resistance levels back in September, when it was trading as low as
11.14, it exploded to reach a 2006 high of 14.26 back on January 9, thereby
confirming a bullish pattern that could next take this ETF as high as 16, which
is a level not seen since 2000.
The fundamental reasons behind the surge are tied to a stronger Japanese
economy. Gross domestic product has been trending upward due to more robust
export expansion. In fact, there have been five consecutive measures of
month-over-month growth, leading both UBS and Lehman Brothers to raise their GDP
estimates for the last quarter and upcoming year.
The personal income environment remains healthy, and consumer confidence has
recovered sharply as the job market shows signs of firming. Growing consumer
confidence is important to lifting the nearly ingrained deflationary mind-set
that has prevailed there for years now. So far, domestic retail investor
interest has been moderate, but as consumer confidence grows, the Japanese
equity markets will benefit; the two have been linked in the past, and growth
can be mutually reinforcing.
Foreign investors flocked to buy shares of Japanese companies in the second half
of 2005 because valuations were low in spite of improving profitability, a
measure that has been rising since the mid- to late-1990s due to expanding
margins. The Nikkei and EWJ became overbought by late 2005, but this attests to
their strength rather than to speculation. Selling by foreign investors has been
responsible for much of the recent decline, which is linked to concerns over
monetary tightening that may strengthen the Japanese yen and dampen exports.
Among the top holdings of iShares MSCI Japan Index, there are a couple of
holdings that have soared early in 2006. Sony is up 22.1 percent after
announcing third-quarter results that indicated accelerating growth and
profitability for the remainder of this year. Its competitor Matsushita Electric
Industrial also has made a double-digit gain, up 11.5 percent. Canon is up a
more modest 3.7 percent, and the fund’s largest holding, Toyota Motor, has
gained 2.1 percent for the year.
In our view, the risk of not participating in foreign markets is most often
greater than that of being long and wrong from time to time. Nevertheless, when
it comes to exchange-traded funds such as EWJ, we rely on momentum to tell us
when to buy or sell a fund. Once a bull market starts rolling, it doesn’t often
give people a clear opportunity to enter, but if you rely on momentum, you can
eliminate the emotional second-guessing that often accompanies such investment
decisions.
