Japanese shares set to surge, lifted in part by the US recovery
As we go further into 2011, we expect the global economy to undergo a moderate but firm recovery. For the Japanese economy, this should translate into an upturn in exports in 2Q 2011. Market participants will likely begin to factor these two events - the global economic recovery and the positive impact on Japanese shares - from early next year.

Japanese firms have significant profit leverage
If the global recovery continues to gain traction, Japanese corporates should see a sizeable increase in profits. We think the extent of these increases are likely to be reflected in Japanese stocks around the FY3/11 reporting season.
Consequently, we look for Japanese shares to outperform other major stock markets from 1H 2011.

Valuations remain low
Japanese shares are at historically low levels based on Shiller P/E and even when compared to other global shares. We do not believe that investors have sufficiently taken into account the implications of these low valuations once the global economy recovers.

Eoin Treacy's view Japan was a regional and global underperformer throughout 2010. The export sector struggled with the strength of Yen, economic growth was un-impressing and political instability sapped confidence. We have argued for some time that a weak Yen is likely to be an important catalyst for the Japanese stock market and is therefore well worth monitoring.

The Yen Trade Weighted Index bottomed in July 2007 and accelerated higher during the financial crisis of 2008. It peaked near 135, pulled back to 115 and has plotted a progression of higher or equal reaction lows since April 2009. It hit a new recovery high in August 2010 and has been ranging below 140 for the last four months. It retested the high last week and a sustained move below the 200-day MA, currently near 130, would be required to question the consistency of the medium-term uptrend.

The USD/JPY rate makes up 53% of the Trade Weighted Index. The Dollar remains in a more than three-year downtrend trend against the Yen. It found at least near-term support near ¥80 in November and continues to hold above that level. However, it needs to take out the December peak near ¥84.50 to break the 10-month progression of lower rally highs and ideally needs to sustain a move above ¥90 to clearly signal a return to Dollar demand dominance.

The Topix has been ranging, mostly between 800 and 1000, for more than two years. It has rallied impressively over the last six weeks and is currently in the middle of its range. However, a sustained move above 1000 will be required to indicate a return to medium-term demand dominance. The 2nd Section Index of small caps has rallied even more impressively recently but also needs to break out from its base to indicate a return to medium-term demand dominance.

In Comment of the Day on November 16th, I pointed out a small number of Japanese shares that were outperforming and were therefore candidates for upside leadership in the event that significant investor interest returns to Japan.

Isuzu Motors remains in a consistent medium-term uptrend, defined by its progression of higher reaction lows. These would need to be taken out, with a sustained move below ¥300 to question medium-term upside potential.

Softbank remains in a consistent medium-term uptrend and would need to sustain a move below the 200-day MA to question potential for additional upside.

Nippon Light Metal has posted a progression of higher reaction lows since March 2009 and has been consolidating in the region of the ¥150 for three months. A sustained move below ¥130 would be required to question potential for a successful upward break.

Alps Electric formed a Type-2 bottom with right hand extension (as taught at The Chart Seminar) from March 2009 and broke successfully above ¥600 in April 2010. It found support at that level once more in August and hit a new recovery high this week. A sustained move below ¥800 would now be required to question medium-term upside potential. Hitachi has performed similarly, particularly over the last year.

Fanuc is somewhat overextended relative to the 200-day MA as it tests the 2007 peak near ¥18,000. However, a sustained move below the 200-day MA, currently near ¥10,500 would be required to question the consistency of the medium-term uptrend.

Aozora Bank, Minato Bank and Towa Bank remain relative strength leaders in the financial sector.

Of the shares mentioned in the Deutsche Bank report above, Teijin is in the process of breaking upwards from an 18-month first step above the Type-2 bottom.

Mitsubishi Tanabe has been volatile but has held its progression of higher major reaction lows.

Mitsubishi Electric has ranged near the April peak for the last month and a sustained move below ¥800 would be required to question medium-term upside potential. Aisin Seiki has a relatively similar pattern. Itochu Corp is also rallying towards it recovery highs.