January 6, 2014 - Play the Japanese Recovery, But Be Smart About It
The global recession was hard on a lot of nations, and Japan was no exception. The nation's GDP shrank 0.7% in 2008 and another 5.2% the following year. By comparison, global GDP rose 3.1% in 2008, and fell just 0.7% in 2009.
Japan's problems lingered while the rest of the world started to recover, but over the last year there have been some encouraging signs that the economy is getting back on its feet. Improvements can be traced back to reforms put in place by its newly elected President Shinzo Abe, who took office in December 2012.
He put in place an economic plan referred to as "Abenomics", which aimed to weaken the Yen to curb the nation's deflation and lower unemployment.
The changes are starting work. Japan was dealing with deflation of -0.1% before President Abe took office, but by October that turned into inflation of 1.1%. Unemployment sat at 4.3% at the start of 2013, but fell to 4% by the end of the year. Wages have not yet started climbing, but with unemployment falling it is only a matter of time before they do.
There are clear signs that Abenomics is working, but the clearest evidence can be seen in the Japanese equity market. There is an old saying that goes "let the markets do the talking", and so far they are telling a good story.
For a clearer picture on the Japanese market, you can simply look at iShares MSCI Japan (EWJ). EWJ is set up to track the MSCI Japan Index, so it gives an accurate picture of what is taking place in Japan's equity markets. In 2013, EWJ rose an impressive 25.9%.
Chart courtesy of stockcharts.com
All signs are pointing to strength in the Japanese economy, but it will not be smooth sailing going forward. The biggest threat to the economic recovery will come in April when Japan raises its sales tax. Economists are expecting minimal wage hikes, so following the tax increase it is reasonable to assume that consumer spending is going to take a hit. Consumer spending accounts for 50% of the nation's economy, so any slowdown is sure to raise concerns.
Whole most analysts agree that a slowdown is coming, most believe that it will not be enough to push the country into a recession, mainly because of ongoing economic stimulus programs and expected growth in exports.
I would want to take a cautious approach to investing in Japanese stocks until we see for sure what impact the pending tax hikes have on its recovery. As a result, I would prefer to take a hedged approach on a diversified position such as EWJ.
A nice hedged trade on EWJ would be the June 9/12 bull put credit spread. To set up this trade, you would sell the June 12 put while buying the same number of June 9 puts for a credit of 50 cents. It is important to note that the stock is currently trading at $11.96, so the trade is starting slightly out-of-the money. In order to realize our target return it will have to trade above $12 at expiration. The trade has a target return of 20%, which is 43.2% on an annualized basis (for comparison purposes only).