As short-sellers in Tokyo become increasingly bearish, the pessimistic outlook may indicate a potential buying opportunity for Japanese stocks and related exchange traded funds.

Over the past week, the iShares MSCI Japan ETF (NYSEArca: EWJ) has increased 1.1%. Meanwhile, yen-hedged Japan ETFs, WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) and db X-trackers MSCI Japan Hedged Equity Fund (NYSEArca: DBJP), rose 1.1% and 2.2%, respectively. Year-to-date, EWJ is down 6.4%, DXJ is 2.6% lower and DBJP dipped 4.6%.

Short interest on Tokyo’s bourse rose to its highest on record this month as the Topix index declined 7.7% from a six-year high back in September, InvestmentNews reports.

Specifically, bearish bets made up 36.6% of all transactions on the Tokyo Stock Exchange on Oct. 14, the highest since the exchange started issuing figures in 2008. On Oct. 24, the figure dipped to 33.4%.

“Fear is hitting extreme levels and it’s time to get into the market,” Nader Naeimi, head of dynamic asset allocation at AMP, said in the article. “When these sentiment indicators flash excessive pessimism, it usually suggests we’ve reached the lows.”

Since 2009, Japanese equities have rallied 9.7% on average over the following three months after a jump in bearish bets. For instance, when short sales accounted for over 36% of daily trading in April, the Topix increased 9.5% over the next three months. Since the record short-sale ratio on Oct. 14, the Topix has only rallied 2.3% so far.  [Advantages With Yen Hedged ETFs]

Additionally, Sean Darby, chief global equity strategist at Jefferies, points out some 889 of the Topix’s 1,811 companies are trading below the value of their net assets, which should be a warning signal to hedge funds that are excessively bearish.

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