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What's Next for Stalling Japan ETFs?

NEW YORK ( FMD Capital Management) -- The Japanese economy got off to a roaring start through the first half of 2013 and then subsequently stalled due to concerns about the effectiveness of the governments quantitative easing efforts.

Prime Minister Shinzo Abe has been on a quest to inflate the Japanese economy through aggressive strategies to reverse decades of stagflation. However, the resulting inflationary effects have raised consumer prices and hampered confidence in Japanese stocks.

A quick check on the iShares MSCI Japan ETF (EWJ) shows the fund has been mired in a broad sideways trading range since hitting a high in May. This index represents over 300 Japanese stocks that have struggled to match the growth of the U.S. market over the last six months.

Courtesy of StockCharts.com

Investors have made big bets on Japan this year as Index Universe reports both EWJ and the WisdomTree Japan Hedged Equity ETF (DXJ) in the top five for year-to-date inflows.

Combined, these two ETFs have garnered over $14 billion in new assets in 2013. This WisdomTree fund differentiates itself from the widely held iShares Japan ETF by carrying an additional currency component that hedges its exposure to the Japanese yen. Put simply, DXJ will outperform EWJ when the yen is falling in value against rival foreign currencies.

Despite the fantastic gains early on, both funds have been unable to break above their prior highs and consistently been bumping up against overhead resistance. This may be due to an inverse pattern in the CurrencyShares Japanese Yen (FXY).

Courtesy of StockCharts.com

Both EWJ and DXJ were spurred to new heights as FXY fell precipitously early on. However, that growth was curtailed when the yen started to level out. Global investors are obviously watching the manipulations in the currency markets closely as a signal for strength in Japanese stocks. There is a strong inverse correlation between the two.

It's my belief that a breakdown in FXY below its current levels would precipitate a breakout in EWJ and DXJ to new highs. Consequently, a move for FXY back above its 200-day moving average at $100 would be a negative sign for Japanese stocks and likely send investors fleeing for the safety of cash.

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