How to Play a Japanese Stock Rally

By Joseph Cafariello

Tuesday, June 11th, 2013

George Soros had been heavily invested in Japanese stocks since their recent run first began late last year. He netted over a billion dollars riding the Yen down and Japanese equities up, as the Nekkei index skyrocketed from 8,600 in November to 15,942 on May 22 nd a rise of some 85% in 6 months.

After sitting out the 20% correction of the past 3 weeks, Soros is jumping back into Japanese equities with both feet. Is this a good time to play follow-the-leader? Or did Soros jump the gun before todays Bank of Japan decision?

Correction Amid the Stimulus Run

The spectacular run up in Japanese stocks since late last year was sparked by the Bank of Japans plan to adopt U.S. style quantitative easing measures of low interest rates and monthly bond purchases both designed to lower the bond yield to make it cheaper for corporations to raise capital through bond issuances, and weaken the Yen to increase export income.

But this is not your typical injection of liquidity the way countless other nations have been doing it. This is an outright flooding of Yen into circulation to double its liquidity by the end of 2014, resulting in a substantial debasement of the Japanese currency. Hence, the run up in Japanese stocks driven by Yen devaluation, itself driven by BOJ stimulus.

Long term bull runs usually follow a 5 leg pattern, where the odd number legs (1,3,5) are bullish and the even number legs (2,4) are corrective. Japanese equities have been in a wave-2 correction for the past three weeks now.

Stocks rose and the yen weakened between November and May at a very rapid pace, driven by expectations for Abenomics and Kuroda-nomics, exceeding the pace of the economys fundamental improvement, Hiroaki Muto, a senior economist in Tokyo at Sumitomo Mitsui Asset Management explained to Bloomberg. The markets are now going through an adjustment phase from the too-rapid moves.

BOJ June Meeting — Expectations

Leading up to the BOJs June 10-11 meeting, Japanese stocks picked up a little, expecting the Bank of Japan to announce further Q.E. measures. If the bank does, upward wave-3 would commence. If the bank doesnt, corrective wave-2 would continue a little longer.

But officials went into the meeting deeply divided. Bank governor Haruhiko Kuroda made clear he wants to avoid incremental steps of progressively increased stimulus, preferring to simply keep stimulus steady at current levels.

Others wanted increasing stimulus, including doubling short term bond maturity terms from the current 1 year to 2 years, keeping stimulus money in circulation longer before being extracted back out of the system at bond maturity.

Supporters see the plan as necessary to stabilize bond markets. The recent fall in bond prices of late indicates to them that the high from the first stimulus pill has run its full course, and additional monetary easing is needed to push equities further along.

But opposers consider lengthening the duration of bonds as one of those incremental steps that failed so miserably in the past. They believe it will introduce further volatility and increase the risk of inflation, bringing rising prices sooner than the Japanese economy can grow to absorb them. Remember, inflation is ok as long as the economy can grow at a fast enough pace to keep up.

Muto also noted there is an additional political incentive in upping the stimulus. [Prime Minister] Abes government will probably come under pressure to provide more fiscal spending to shore up the economy as the upper-house election approaches, Bloomberg quotes. I expect Abe to decide to draft an additional fiscal spending package.

Prime Minister Abe already announced last week that his third arrow of stimulus designed to boost growth and reduce regulation would be implemented this autumn. With full confidence the Japanese economy will continue to expand fast enough to absorb the stimulus, Abe is not worried about taking incremental steps this time around.

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BOJ June Meeting — Outcome

While America slept last night, the BOJ announced there would be no changes to its stimulus program. Neither will it change the duration of short term bonds to two years, leaving them at one. Those opposed to incremental steps have won the day, along with Yen holders.

But investors in Japanese equities and bonds are losing once again. This by itself is an indication that normal market forces are not in play. In normal market behaviour, equities and bonds move opposite each other. Yet in Japan, as in America, both are moving mostly in tandem due to federal stimulus in both countries. As long as these huge injections of stimulus persist, we simply cannot be trading according to traditional market manuals. Standard market behaviour is out the window for the time being.

So did Soros get it wrong? Did he jump into Japanese stocks too soon? Something tells me he knows something the general public doesnt.

Remember, Japanese Prime Minister Abe is still prepared to shoot his third arrow this autumn, indicating more stimulus measures to come.

And even if this corrective wave-2 were to follow a typical 50% retracement, the Nekkei could drop to 12,300 — the halfway point along its 7,300 point run from November to May — without causing irreparable damage. The Japanese index could fall another 1,000 points from here and the 5-wave uptrend would still be undamaged.

Todays news from the BOJ has already provoked bears into declaring the Japanese equity bubble has popped. However, although the BOJ did not increase stimulus today, neither did it curb it. It is still on track to doubling the money supply by the end of 2014. That alone should be enough to keep pushing Japanese equities through two more up cycles, waves 3 and 5.

Corrective wave-2 may not be over yet. But neither is stimulus, nor the bull run in Japanese equities. And it seems George Soros is expecting that too.

Selective Picking

Yet Soros isnt just buying anything that says made in Japan on it. His privately held investment firm Soros Fund Management LLC is focussing on select large and medium cap companies with strong exposure to markets abroad.

Small cap companies are usually the most volatile, since their weaker cash position coupled with high debt makes them susceptible to even small shifts in the economy. Soros firm seems to be focussed on exporters.

BOJ monetary stimulus is making Japan more competitive versus other nations. This advantage is external, not internal. To benefit from what the BOJ is doing involves capitalizing on the disparity between Japan and the rest of the world.

As such, companies with business activities overseas will likely fare better than those focussed primarily on the domestic market. Japanese exporters, including automotive and electronics companies, will benefit the most from stimulus specifically engineered to increase export profits.

Yet one should be prepared for a good deal of volatility over quick periods of time. Margin should be used sparingly, with options likely providing the best profit potential relative to money invested.

And if you are really confident a market will rise again, there is always the double-down method. But you need deep pockets to implement that plan, which involves buying more and more as prices continue falling. If todays BOJ decision has forced George Soros to double down, I dont think his accountants are too worried about it.

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