Japan – Back from the Brink?

Editor's Note: This article, by Alec Young, International Equity Strategist at Standard & Poor's, was originally published in the February 2010 edition of Capital IQ's Monthly Market Observations, pp. 34-36.

Japan is the largest overseas stock market in the world, recently weighing in at 14.6% of free float adjusted international equity market capitalization. Just when its long-term underperformance has led many investors to thoroughly dismiss it, Japan is finally outperforming. It’s the strongest major stock market in the world year-to-date by a wide margin, rising 9.3%.

Given its large benchmark weight, being underweight Japan when it outperforms risks detracting materially from performance. In addition, from a contrarian sentiment perspective, the mere fact that Japan has been relegated to perennial underweight status implies to us that it is due to post much more competitive returns. After years of underperformance, we believe everyone who would want to lighten exposure to Japan likely already has. Additional turnaround drivers we foresee are outlined below.

S&P Economics expects Japan's economy to expand within a range of 1% to 1.5% in 2010, up from 2009’s estimated 5.4% contraction. With domestic demand remaining weak amid deflationary pressure and political uncertainty, we believe a recovery is being driven by improving external demand. The consensus expects Japanese corporate profits to rebound sharply in 2010 as China and the U.S., Japan’s two largest export markets, continue to recover. Through November, these two markets accounted for 35% of Japan’s 2009 exports. Furthermore, Japan derives an additional 34.2% of its export revenue from other faster-growing Asian economies like South Korea, Singapore, Hong Kong and Vietnam.

Japanese export earnings should also benefit from a more stable yen. The country’s export EPS suffered in 2009 as the yen rose 9.5% vs. the U.S. dollar, making the country’s exports less competitive in the U.S., as well as in China and Hong Kong, both of whose currencies are pegged to the greenback. In order to maintain 2009’s torrid rate of appreciation, the ¥/$ exchange rate would have to average ¥84.7/$ this year, 6.7% above current levels of ¥90.8 /$, by our analysis.

As a result of improving Asian and U.S. demand, as well as easing year-over-year currency comparisons, the Japanese export recovery that began last March should continue to accelerate, by our analysis.

Lastly, while analyst EPS revision ratios in other foreign markets peaked in the fall, Japan’s continue to make new cyclical highs.

Also, Japan is trading at a historically cheap level, at 18.2X 2010 consensus EPS estimates, a 14% discount to its 10-year average of 21.2X forward EPS. We believe this increases the likelihood of more competitive returns in 2010.

Several ways to profit from this is by buying Japanese ETFs JOF, JEF and DJF.