Steer Clear of a Radioactive Japan Stock Play

Originally published in The Weekday Trader, March 15, 2011.

Though some Wall Streeters see a buying opportunity in a sold-off Japan-stock ETF, the shares could remain under pressure for a long time.

Conventional wisdom on Wall Street suggests that tragedies that incite panicky selloffs in security prices represent buying opportunities for smart, patient investors.

The earthquake that struck Japan last week qualifies as a tragedy on an enormous scale, and the action in Japanese stocks, with the Nikkei Index plunging 16% in two trading sessions, certainly speaks to a selloff.

There's been an equally strong reaction by the most-popular exchange-traded fund listed in the U.S. that invests in Japan: the iShares MSCI Japan Index Fund (ticker: EWJ). At its lows in Tuesday's trading at $9.24, the ETF had fallen 16% in just three trading days. (Shares subsequently recovered Tuesday, erasing the day's losses.)

How quickly money has come out can be measured -- it's about $900 million. "We know the capital's leaving," says Nicholas Colas, chief market strategist at BNY ConvergEx Group. "What we don't know is where it's headed."

Colas isn't buying the buy-on-weakness argument and neither should prudent investors. There are good reasons, Colas argues, to believe that the capital won't return to the EWJ exchange-traded fund in either the near term or long term, at least at the levels that the iShares Japan fund has attracted this year.

That's thinking that flies in the face of modern Wall Street orthodoxy, which posits that it's wise to buy those selloffs. As Uwe Parpart, chief economist and Asia strategist at Cantor Fitzgerald, told The Wall Street Journal Tuesday about the Nikkei's pullback, "How many times in a lifetime do you see a major market drop nearly 20% in two days? Professional investors should and will look at buying opportunities at this point."

Indeed, the Japan ETF has been a big target of so-called hot money on Wall Street lately. Year-to-date, $1.2 billion in fresh capital has flowed into the fund, the third-largest inflow for any single ETF this year.

Sam Seiden, vice president of education for Online Trading Academy, echoes this buy-on-weakness thinking when he says that "markets collapse into high-quality demand levels that turn out to be incredible buying opportunities."

But there are what Wall Street refers to as "risk events" going on in Japan -- new developments that make an already-tragic situation even worse. On Tuesday, a new earthquake struck Japan, though it lacked the severity of the original event. Certainly, the nuclear crisis is far from over and the problem seems to be expanding by the hour as a crew of technicians fight to prevent three nuclear reactors on the northeastern Japanese coast from melting down. Even in Tokyo, radiation levels were detected as being 20 times above normal, according to the New York Times, though officials stressed that amount currently poses no health threat.

The continuing crisis in Japan should be problematic for the fortunes of the iShares Japan fund, especially if the selling pressure continues to mount in coming days -- Tuesday's trading volume of 365 million shares was 15 times the daily average of 23 million -- and buying interest turns cool.

"How much of this capital leaves during the upcoming week, and where it goes, will be a useful guide to how investors are reacting to the country's near-term challenges," Colas says.

Conventionally, that money would eventually flow back into the fund.

But Colas believes that investors have been scared out of single-country ETFs. Their experience earlier this year with Market Vectors Egypt Index (EGPT), which plunged 16% in less than a month as a popular uprising drove the nation's president, Hosni Mubarak, from office, already left them skittish about exposure to a single country. Regional ETFs might provide more diversification.

"The essential question to ask about the EWJ is "Did the investment thesis change over the weekend?" Colas says. "I think the answer to that is yes."

Free Class
Online Trading Academy logo