How to Bet on Japan's New Boom

Tickers in this article: CAJ DXJ EWJ HMC NSANY TM USDJPY=X
NEW YORK ( TheStreet ) -- After languishing for years, Japanese stocks have become red-hot.

During the past year, the Tokyo Stock Price Index climbed 25.0%. Seeing the gains, investors have flocked to Japan ETFs. In the past two months, iShares MSCI Japan Index ETF (EWJ) has recorded more than $1 billion in inflows, while WisdomTree Japan Hedged Equity (DXJ) had $800 million in flows, according to IndexUniverse.com.

The rally gained steam as it began to seem likely that Shinzo Abe would win the December election for Prime Minister. Since Abe claimed a resounding victory, stocks have soared.

Investors have applauded the new prime minister because he has pledged to lift Japan out of the stagnation that has plagued the country for decades. In his speeches, Abe has promised a massive spending program to stimulate the economy. He has also called on the Bank of Japan to increase its purchases of government bonds, a process that could lower interest rates.

Can the stock rally continue? Yes, argues Jeremy Schwartz, WisdomTree's research director. Schwartz says that Japanese stocks have reached bargain prices. During the past decade, prices of the Tokyo market fell from 2.5 times book value to about one times book. In contrast, the S&P 500 trades for 2.3 times book. "Even after the rally of the last few months, Japanese stocks are still relatively cheap," Schwartz says.

Part of what makes Schwartz bullish is the weakness of the yen, which has fallen steeply since November. Traders have been dumping the currency because they figure that bond purchases by the Bank of Japan will lower interest rates, a process that would make yen investments less appealing to foreigners.

In the past, Japanese stocks have tended to rise whenever the yen fell. The reason is that a decline in the currency makes Japanese exports cheaper for foreigners. That is an important boost for an economy that relies on many giant exporters, such as Toyota (TM) and Canon (CAJ) .

In recent years, the yen has soared as investors sought a safe alternative to the euro and other shaky currencies. The strong currency punished Japanese exporters. But now that the yen is sinking, Japan has emerged as one of the top-performing stock markets in the world.

While the falling yen may help export sales, it can be a mixed blessing for U.S. investors. The problem is the weak currency makes Japanese stocks less valuable for foreigners. So if the yen drops 10%, as it did in recent months, the value of a Japanese stock would decline by that amount for a U.S. investor.

To bet on Japan at a time of a falling yen, investors should prefer WisdomTree Japan Hedged Equity, says Dennis Hudachek, an analyst for IndexUniverse.com. Using futures and other tools, the fund neutralizes the impact of the currency moves on U.S. investors. "With the yen weakening, the currency hedge could have tremendous value," says Hudacheck.