According to Biriniyi Associates, investors threw more than $1 billion into Japanese exchange-traded funds (ETFs) last month – second only to U.S. energy funds and more than agriculture, large-caps and mid-cap stocks combined.

They couldn’t have placed their bets at a worse time.

Amidst fears of multiple nuclear meltdowns, the benchmark Nikkei 225 Index plunged 10.55% yesterday (Tuesday) after a 6.2% decline on Monday – a two-day decline of 17% since Friday’s devastating 9.0-level earthquake and tsunami. More than $650 billion in shareholder wealth has been vaporized.

As a veteran trader and longtime expert on Asia, it’s a story that I’ve heard countless times: Japan was supposed to regain what it once had – a vibrant economy that helped lead the world in the years following World War II, and that finally achieved global dominance in the late 1980s.

[ad#Google Adsense]Somehow, however, that never happened. But it didn’t discourage the believers.

Three Views of the Rebound That Never Came

On Thursday, the day before the Sendai earthquake and tsunami, the Nikkei closed at 10,434.38. That means the index is down 73% from its record intra-day high of 38,957.44, reached Dec. 29, 1989 – just before Japan’s so-called “Lost Decade” began in earnest. (Sadly, that term should be listed in the plural – as in “Decades,” with an “s” – given the perpetual malaise that has defined Japan’s economy ever since.)

For some strategists and traders, the expected Japanese rebound was all about currencies and exports. Members of this group believed a weakening Japanese yen and China’s growth would transform Japan into an exporting giant. In this role, Japan would become the supplier of choice to the newly emerging economies of the Asia region, the key one being China.

Those subscribing to this argument believed one of two scenarios would make this happen. Either the U.S. dollar was going to strengthen against the yen, or the Bank of Japan (BOJ) was going to begin printing money, which would drive the yen lower against the dollar.

A second group of believers based their expectations of a Japanese economic renaissance on mathematical probabilities and financial valuation.

Japan, this group believed, was undervalued – and in a big way. The U.S. Standard & Poor’s 500 Index had shot up 91% from its March 2009 bear-market lows, while the Nikkei managed to tack on only 47% through the same period (through last Thursday, the day before the earthquake). Therefore, the odds favored a continued rebound in Japan’s shares, this group reasoned.

A third group of believers subscribed to what I like to call (for lack of a better term) the “coattail theory.” Somehow, this island nation that is the world’s No. 3 economy would finally pull itself up by the bootstraps of the global inflation that reflates all economies. This is nothing more than a variation of the “rising-tide-lifts-all-boats” theory.

My outlook for Japan has been the same for several years now, and wasn’t dramatically changed by the events of last week: The country’s huge debt load – as much as 259% of gross domestic product (GDP) depending on which statistics you believe – will act as an anchor on its economy, meaning there are better (and less-risky) places to put your money.

Absent the earthquake tragedy, Japan’s economy might have managed to sputter along at 1% per year. But now – following the unprecedented $186 billion post-quake infusion by the Bank of Japan – that country’s debt load is obviously headed much higher. And that puts both Japan’s growth and its yen at real risk.

In my mind, there’s no question that Japan will rebuild and its people will recover. But we can’t say the same about the country’s currency.

A False Rally

Many people won’t agree with my analysis, especially since the yen immediately rallied to 80.60 per dollar following the earthquake – an exchange rate that’s only a stone’s throw from the yen’s all-time-record high of 79.75 versus the dollar, a level reached just after the Kobe earthquake (also known as the Great Hanshin earthquake) of 1995 following that earth shaker. So this pattern is very familiar to currency traders who are definitely feeling a sense of déjà vu.

The immediately stronger yen is due partly to the expectation that Japanese companies will repatriate assets as part of the rebuilding process. And it’s also due to global traders adhering to the script that they always follow in the aftermath of any natural disaster or geopolitical upheaval by dumping their riskiest holdings.

Neither catalyst will last. I say this because the last thing Japan needs right now is an abnormally strong yen. Not only does this hurt the exports upon which 14% of Japan’s $3.59 trillion economy is based (because it makes them more expensive for the rest of the world), but a more-expensive yen could cripple the domestic recovery efforts that will be so critical in the months to come.

That’s why many experienced traders – myself included – expect the Bank of Japan to intervene further in a yen-selling maneuver that will help shore up the Nikkei Index and free up liquidity for the country’s industrial base, which is understandably traumatized by all that’s happened since Friday’s earthquake.

In other words, Monday’s aforementioned infusion – a policy-level response by the BOJ that was unprecedented in its quickness – was just the start. Indeed, my sources in Tokyo’s financial district told me early yesterday that the BOJ was meeting again to consider further measures – something the media finally confirmed later in the day.

[ad#article-bottom]But let me caution you – this is not a trade for nervous money, or for the faint of heart. No global event ever is. The Bank of Japan has held interest rates near zero for years in a misguided attempt to jumpstart that nation’s economy, so the only weapon left in its arsenal is currency manipulation. That reality makes what’s happening in Japan’s markets right now especially dangerous and potentially volatile, too.

Moves to Make

I fully expect short-term momentum traders who are driven by memories of the Kobe quake to make a run at 80 yen to the dollar, which would force Japan’s central bank into an additional round of massive intervention.

Longer-term, though, I expect reality to settle in as global traders – the vast majority of whom are already circling like sharks – are drawn into the fray by weaker earnings and by what could be crippled national industries, especially if there is a serious radiation leak.

That may sound opportunistic, or even callous. But that’s the reality of the global capital marketplace.

Here are three ways to play the scenarios that I’ve outlined here:

  • Short Term: Short the yen and buy the dollar. Be careful, though. There are lots of shorts to get cleared out around 80 yen to the dollar before this trade gathers momentum. And it will take true nerves of steel to stare down the Bank of Japan.
  • Medium term: Buy ProShares UltraShort Yen Exchange-Traded Fund (NYSE: YCS). The 20% run-up experienced after the Kobe quake was very quick and it’s taken 15 years for the yen to revert to these levels. But that’s true with so-called “blow-off” moves, in that they frequently are event driven. This time around we’ll probably see a similar pattern play out, albeit one that unfolds at a much faster pace because global financial markets are much more closely integrated now than they were 16 years ago.
  • Long term: Short Japanese stocks. To do this, use something like the iShares MSCI Japan Index ETF (NYSE: EWJ), or “put” options on EWJ, as your vehicle. It will take weeks, or even months, for analysts to factor in the true economic impact of the continuing catastrophe, and there are undoubtedly going to be downgrades along the way. Anybody caught holding Japanese equities in 1995 got smacked around for a year. And this time around the damage will be much more severe.

— Keith Fitz-Gerald

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* Source:  Money Morning