1 of 5 11/13/2008 3:23 PM CurrencyShares Japanese Yen Trust (FXY) This ETF tracks the value of the yen against the U.S. dollar. $101.85-3.33 (-3.17%) 11/13/2008 3:59 PM FXY is one of our BUY FIRST stocks! October 17, 2008 At a Glance Action: Buying 3% Price When We Released Our Intent: $98.33 Buy Below: $105 Why Buy: Japan had its own real estate and stock market crises more than 15 years ago and has avoided the crunch that's hitting the United States, Europe, and Australia hard right now. The Japanese yen is near 20-year lows against the U.S. dollar and should strengthen against it over the coming year or so. While U.S. and European interest rates are likely to decrease, rates in Japan will likely stay unchanged or increase, making the yen more attractive. This position should provide healthy returns -- even in this volatile environment -- with very little downside risk. The Big Picture For our first Motley Fool Pro purchase, we set out to find an investment poised to perform well even if the U.S. and other major economies enter a recession. But we also wanted one that will do well when the economy begins to recover. It's rare for an investment to shine in both good markets and bad -- but we believe we've found just that opportunity across the Pacific. After more than a decade of being undervalued, the Japanese yen has quietly initiated a gradual but steady comeback. It's up nearly 10% this year, while the S&P 500 is down 37%. We believe the long-overlooked yen is likely to gain value against the dollar over the next one, two, even three years. And because we're so bullish on the yen, we'll be purchasing an exchange-traded fund (ETF) that tracks its value against the U.S. dollar: the CurrencyShares Japanese Yen Trust (NYSE: FXY). The yen is a great diversification away from dollar-based assets, which (you've probably noticed) are losing value and may continue to fall well into 2009. The yen has also been an excellent hedge against the S&P 500, moving inversely to it over the past year. We expect this trend to continue for now -- but we also expect the yen to hold up and ultimately increase even when the S&P 500 advances. Our Take And we re not the only ones who like the yen s prospects versus the dollar. The Motley Fool CAPS community has been consistently bullish on the CurrencyShares Japanese Yen Trust over the past six months, with more support coming in the past month with all that s happened in the U.S. markets.
2 of 5 11/13/2008 3:23 PM Take a look. Outperforms: 63 of the 64 CAPS all-stars (98.5%) rating this ETF have picked it to outperform, including all 17 of the all-stars (100%) ranked in the top 1% of the entire CAPS universe. 6-Month CAPS Ratings History for FXY: 10/10/08: 74.32 (4 stars) 9/12/08: 56.28 (3 stars) 8/15/08: 62.90 (4 stars) 7/18/08: 79.48 (4 stars) 6/20/08: 72.07 (4 stars) 5/23/08: 67.08 (4 stars) Now, let's step into our Foolish Time Machine and set it for 1989. Japan had just begun to suffer from the collapse of one of the biggest real estate and stock market bubbles in modern history, a time that became known as the country s lost decade. The bad news is, nearly 20 years later, Japan's markets are still a shadow of their former highs. But the good news for yen buyers is Japan essentially has a 20-year jump start on the rest of the world when it comes to surviving real estate bubbles -- it has already emerged stronger from its own. The four most actively traded currencies in the world, in order, are the U.S. dollar (the world's reserve currency), the euro, the yen, and the British pound. Of the four, we believe the yen will strengthen the most over the next few years. As the United States, the U.K., and most of Western Europe grapple with the credit debacle, Japan sits largely unscathed. Today, Japan's banks are among the best-capitalized in the world, avoiding most of the fallout from this year's global credit crisis. In fact, Japanese banks have reported only $17 billion in subprime mortgage writedowns so far in 2008, while the damage to banks worldwide has easily eclipsed $500 billion. As of July, 549 trillion yen sat in deposit accounts at Japanese banks, while just 403.8 trillion yen sat on bank loan books -- meaning that Japan faces zero risk of mass mortgage defaults. Plus, Japanese consumers enjoy one of the highest savings rates in the world, with $14 trillion (U.S.) in household assets and half of that in savings. Meanwhile, the Japanese government holds nearly $1 trillion in U.S. currency reserves. Let's recap: The United States and Western Europe are burdened with debt and cash poor. Japan is cash rich and has reasonable debt. So why hasn't the yen ballooned? For years, Japan has been helping out its export industry by buying dollars and selling yen to keep the value of its own currency low. But on Oct. 14, the Bank of Japan started offering the world unlimited dollars to help ease the credit crisis. With a world potentially awash in dollars next year and the future of the U.S. financial system uncertain, investors are viewing the yen as a safe haven. Some investment banks argue that the yen appears as safe as -- and is certainly less volatile than -- gold, so demand for it is increasing. There are a slew of other reasons we like the yen and this investment case right now: The yen is cheap. In trade-weighted terms, it's still at mid-1980s prices. Asian currencies, especially the yen, have been kept artificially low for years, but economic events falling into place will start to correct this. Japan is very unlikely to lower interest rates -- they already sit at 0.5% versus 1.5% in the U.S. In fact, Japan increased rates in 2007 and has a very gradual tightening bias, meaning it's more inclined to increase rates in the future rather than lower them. This makes the yen even more appealing. When the U.S., the U.K., and the European Central Bank cut interest rates in September, Japan held steady -- and the yen jumped 4%. All of these governments, as well as Australia, are likely to cut rates at least once more in the next year, while Japan almost surely will not. Japanese households have debt totaling 63% of GDP, according to Goldman Sachs,
3 of 5 11/13/2008 3:23 PM compared with more than 100% debt rates in the U.S. and the U.K. This suggests Japan's economy will hold up -- and bounce back -- better than others because consumers have more buying power. More than half of Japan's exports are shipped to growing Asian nations, including China, so it's likely to weather the Western-focused economic storm better than most. Japan has cash-rich publicly traded companies, with an estimated 60 trillion yen in their cash reserves. These businesses are beginning to purchase worldwide assets on the cheap, as we just witnessed when Mitsubishi UFJ bought a stake in Morgan Stanley (NYSE: MS). This will position Japanese companies, and the economy, strongly for the rebound. Japan is likely to experience stronger growth in GDP per household in 2009 than both the United States and the European Union for the fourth straight year. The yen accounts for a low 3.4% of global currency reserves compared with 2.8% last year -- its lowest level since 1999. With demand for yen increasing, the yen may overtake the pound (currently 4.7%) next year for the No. 3 spot in reserves held. Increased demand almost always means an increasing price. Meanwhile, the dollar is the world's largest reserve currency, at 62.5% of all currencies (according to the IMF). More dollars are hitting the market now, and greater supply usually keeps a lid on the price. This supports our argument that the yen will continue to strengthen against the dollar. After a long bout with deflation, Japan is finally starting to see low levels of inflation (a decade-high 2.4% in August), which, if it continues, could also support the yen s strength versus the U.S. dollar, the euro, and the pound sterling. A healthy level of Japanese inflation is encouraging, in that it may force the Bank of Japan to raise interest rates again at a time when other developed markets are keeping rates low, or even decreasing their rates. In this case, the yen would be in better shape than the other major currencies. Finally, the yen was the best-performing currency in September and the only currency to gain against the dollar. Although we question the value of some investment bankers and their advice, asset managers Putnam Investments, Deutsche Bank AG, Morgan Stanley, and Bank of Toyko-Mitsubishi UFJ all recently recommended the yen. Why? Risks in the United States and Western Europe probably won't dissipate soon, and with interest rates on most major currencies likely to decline, the yen should continue to benefit. Another Catalyst: Currency Carry Trade As if the above wasn t enough, there s one more catalyst supporting the yen. For years, the yen was one of the lowest-yielding (0%, in fact) currencies in the world. This made it a huge favorite among the "currency carry trade" set: These investors borrow a currency with a low interest rate (the yen), sell it, and use the funds to purchase a currency paying a higher rate (the euro or dollar) in order to take advantage of the interest rate difference. Plus, in the past, the yen was steadily losing value against other currencies, too, making the trade all the more attractive. This has resulted in billions of yen being sold in favor of other currencies. However, as the yen starts to gain in value and rates decrease on other currencies, these trades are being closed, which creates fresh demand for the yen. The slow unfolding of massive carry trade positions is like a short squeeze on a stock; these investors must close their positions, and this creates steady buyers of yen. And with each decrease in foreign interest rates, this should accelerate. (The next U.S rate cut is likely on Oct. 29.) You can read more about the carry trade dynamic here. Isn't Currency Risky? If you had asked this question 10 years ago -- or if you're trading currency futures, where timing is vital -- then we d say yes. But with ETFs, currency investments are much more palatable to the average investor. When a strong investment case is found, a currency ETF can make great sense for diversification. It can be viewed as a long-term investment (although we expect to hold this for only for a year or two, but longer if it still looks good), and it s easily bought and sold like a stock. Plus, over our time frame, the yen should prove less volatile than a typical stock.
4 of 5 11/13/2008 3:23 PM Return Expectation A currency won't move as aggressively as an equity, of course, but we're hoping for double-digit returns in this position over the next year-plus. What we like most about CurrencyShares Japanese Yen Trust, however, is its healthy reward potential with low risk. The yen appears nearly perfectly positioned to gain in value over the coming year or two, and it s hard to imagine a scenario where it loses much value over our time frame. What Would Make Us Sell If the Japanese government took aggressive action to devalue the yen, we would not have any good reason to fight them, so we would likely sell our shares of the Yen Trust quickly. Further, although we consider it unthinkable, if Japan lowered interest rates below 0.5%, we would probably sell. Like much of the world, Japan is likely to experience a mild recession in coming months, but that shouldn't affect our investment case. Japan is positioned to rebound much more readily than other industrialized nations, and if Japan s recession is more mild than one in the U.S., the yen should still gain ground against the dollar. Finally, we might sell if the yen experiences a strong run over the coming year, as we believe it may. If the potential reward is diminished following an advance, we'll happily take our money and go. Pro Bottom Line A currency ETF is not going to be a common trade, even for Motley Fool Pro, but all of the pieces came together with the Yen Trust. Among the four major world currencies, the yen is most likely to hold and gain strong value against the dollar, which is our benchmark. As the storm in the U.S. and European economies continues to rage, the yen is largely unaffected -- and when normalcy returns, the Japanese economy should bounce back faster than the West. Good upside potential? Yes. Minimal downside? Yes. We like it. Stop by the new CurrencyShares Japanese Yen Trust board with any questions and comments -- we'll see you there! Stump the Pro David Gardner: Japan s economy is very reliant on exports, and its main export partners have been the U.S. (20%) and China (15%). With more Americans keeping their wallets closed these days and with concerns about China s economic growth during a global recession, how do you expect Japan s export industry to hold up if the yen strengthens (making Japanese exports more expensive)? Jeff Fischer: According to The Economist, in July Japan exported more to China than to the U.S. for the first time, while Asian economies overall now account for nearly half of Japan s exports. As the yen increases in value, exports may suffer marginally, but China and other Asian economies are growing strongly even today, and that growth should help pick up the slack. China s GDP is still expected to grow 8% in 2009 (according to UBS as of Oct. 6). DG: This ETF is based on the yen versus the U.S. dollar. Do you think the dollar could gain strength faster than the yen, even though the yen may gain strength versus other currencies? JF: The yen has much more going for it than the dollar. With the credit bailout, the world is being flooded by dollars, while the outcome of the financial crisis remains uncertain. These events will probably cap any gains the dollar could make in the short term. Interest rates on the dollar are likely to move lower as well, and that s bearish for the currency. Finally, if Japan is any guide, the recovery in the U.S. will take longer than most people estimate, and interest rates may go very low. DG: The Japanese government has worked hard to keep its currency cheap, to help with exporting. What if it initiates new programs to lower the yen s value?
5 of 5 11/13/2008 3:23 PM JF: We believe this is unlikely right now given that the yen is still at relative-value prices not seen in twenty years. However, if the government announced aggressive action to lower the yen s value, it could cause us to sell our ETF.