Four reasons to hedge against Japanese equities

March 28, 2011

What was a contrarian view right after Japan’s earthquake has become consensus: confidence in a V-shaped recovery has powered a 10 percent rally in Japanese stocks since March 15. That outlook still appears likely, but questions surround the speed and strength of the recovery. Investors should hedge against the risk that politics, power shortages, and nuclear troubles prompt investors to turn tail.

Amid a drumbeat of cautiously optimistic forecasts, foreign investors pumped almost $12 billion into Japanese stocks, a surge that helped stoke an unwanted spike in the yen. Even Warren Buffett joined the chorus of support for Japanese equities. The rally also turned up some reconstruction darlings such as generator-maker Denyo <6517.T>, which has climbed 44 percent since March 15; water purification company Nihon Trim <6788.T>, up 48 percent; and lighting company Iwasaki <6924.T>, up 58 percent. 

But bad news out of Fukushima, where radiation continues to seep from crippled nuclear reactors, is nibbling at confidence. Alongside fears of worsening fallout, investors face three other worries. First, that power shortages will create a lasting dent in Japanese output. The quake took out almost a quarter of Tokyo Electric Power’s <9501.T> capacity, prompting it to ration power and force key suppliers to shut down, with reverberations down the entire supply chain. If industry cannot restore its power before surging summer demand, lost production could cost Japan global market share. 

The speed of reconstruction is another concern. Opposition politicians are quibbling over an emergency budget. Even when passed, destruction is so extensive that infrastructure may need not only rebuilding, but relocation. Last and perhaps most important is consumer confidence. Some fear that younger Japanese, already chastened by two decades of job insecurity, will pull their purse-strings even tighter.

Increasing prices for options to sell Nikkei futures suggest that some investors are already turning cautious. Aside from such put options, investors can consider short-selling Nikkei futures. Shorting exchange-traded funds, such as the iShares MSCI Japan Index, provides another way to offset potential losses on a portfolio of Japanese stocks. 

The prognosis is not universally bleak, and Japanese equities are hardly expensive. The forward p/e multiple for the Topix index, using IBES estimates, is an unstretched 12.2. But prudence suggests investors should hedge against the risk that the Tokyo equity market lurches downwards again.

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