It's no secret that the yen is one of the most undervalued freely floating currencies in the world. The Economist does a semiannual survey of the cost of a McDonald's Big Mac in 46 different countries to estimate currency values. This Economist's survey is a nice back-of-the-matchbook indicator of currency values. In the latest survey, the yen comes up undervalued by 28% against the U.S. dollar. But I wouldn't give up on the yen and Japan just yet.

The yen is deeply undervalued because it is a victim of the so-called "carry trade." The carry trade is an investment strategy whereby leverage-seeking investors borrow yen at low interest rates and invest the proceeds in higher-yielding non-yen-denominated securities. The mechanics of the carry trade require investors to sell yen. The popularity of the investment strategy has been a force driving down the exchange rate value of Japan's currency. The carry trade is akin to picking up nickels in front of a steam roller. You better not trip. The high risks of the carry trade make the speculators employing the strategy a trigger-happy bunch. The most minor event can send carry trade investors into a selling frenzy. I cannot tell you when the carry trade crowd will exit their trades, of course, but I can tell you that when the frenzy starts, the yen will soar.

For instance, in 1998, the last time the carry trade was unwound, the value of the yen appreciated by 22% versus the dollar in just 60 days. In 1998, the popularity of the carry trade was much lower than it is today. A swift and powerful move up in the yen is likely.

Even without an unwinding of the carry trade, Japanese equities offer relative value. If the carry trade continues to grow in popularity, the yen will continue to depreciate against the currencies of Japan's major trading partners. Further depreciation in an already undervalued yen will be a windfall for Japanese exporters. Higher corporate profits and higher equity prices are likely in this scenario. So even in the toughest of times for the yen, Japanese equities do still have some appeal--and lots of potential--thanks in part to a "carry trade" crowd that could explode at any time.