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.

Based on that assessment, if you currently have exposure to this country I would continue to hold your positions in the expectation of higher prices. I would closely monitor the yen as an early warning signal of any potential problems that would precipitate a sell off. In addition, having a defined exit strategy to lock in gains in case the tide turns is always a prudent investment discipline.

New investors looking to trade the breakout will have a more difficult decision because of the overhead resistance. My advice is to start small and look to average into new positions on a spike in volume and momentum above the prior high. Another strategy might be to wait for a pullback to initiate a new position at a more attractive cost basis by using the current volatility to your advantage.

No matter what your strategy, remember that international markets can often time trade much differently than domestic stocks. That can be a blessing or a curse depending on the environment and your positioning. That is why using an ETF to diversify your risk and remain liquid is one of the best ways to access these markets.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
David Fabian is a managing partner at FMD Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts and special reports. Visit www.fmdcapital.com to learn more.

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