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It’s official: Japanese stocks are in correction.

After closing at a recent high of 16,291 on Dec. 30, the Nikkei was down by about 14% through yesterday’s close. The iShares MSCI Japan ETF (NYSEARCA:EWJ), the most popular Japan ETF, is down a more modest 9%, due in part to currency effects (the yen tends to rally during “risk off” market conditions).

I’m not big on technical definitions. It’s not particularly important to me whether a market is in “correction,” meaning down 10%, or whether it is officially a “bear market,” meaning prices have declined by 20% or more. What matters to me is what I can expect going forward.

So with that said, what can we expect from Japanese stocks?

Let’s start with valuation. The stocks that make up EWJ collectively trade for 21.79 times earnings, which is on the pricey side, particularly given Japan’s sluggish growth. Of course, trailing P/E can be over- or understated depending on what stage of the economic cycle we are in, so the Shiller Cyclically-Adjusted P/E (CAPE) can be a useful tool to smooth out the noise.

Well, based on the CAPE, Japan has the third-most expensive market in the world, after Sri Lanka and the United States. (And yes, Sri Lanka does indeed have a stock market. I was as surprised as you.)

Looking at the EWJ and the Japanese economy, it’s hard to see how a premium valuation is warranted. Despite all attempted to ignite inflation, the specter of deflation lingers. Sure, Japan’s CPI rose 1.3% in December … but virtually all of that was due to rising energy costs and distinctly not rising consumer prices. Excluding food and energy, Japan’s CPI was up 0.7%.

I suppose it might be good that inflation is tame given that Japanese wages have fallen for 19 consecutive months and are now at a 16-year low.

If I sound a little down on Japan, it’s because I am. While I’m open to the occasional short-term trade, I am definitely what you would call a Japan perma-bear — you won’t find me recommending the EWJ any time soon.

Last year, writing about Japan’s bid for the 2020 Olympics, I wrote that if you considered Japanese stocks a viable investment, you should “close your brokerage account, withdraw the cash balance in a duffel bag, then douse it in gasoline and set it on fire. Because if you believe Japan is investable, you’re inevitably going to lose your money. The fiery duffel bag will help you skip a few steps and save some time.”

Aside from my belief that the Olympic games are of questionable economic value to the host country, I consider Japanese stocks and the yen to be long-term shorts for two related reasons: debt and demographics.

Debt and Demographics Will Weigh Down EWJ

Japan has the highest sovereign debts in the world, quickly approaching 250% of GDP. That’s well more than double the size of America’s debt load, and most of us consider the U.S. to be far too heavily indebted for its own good. And Japan shovels massive amounts of new debt onto the pile every year with budget deficits that have averaged 8% to 10% of GDP since 2008. In 2013, 46% of all government spending was financed with debt.

At the same time, Japan’s population is aging and shrinking. At the risk of oversimplifying, Japan’s debts continue to balloon even while the number of Japanese citizens available to pay it back gets smaller every year.

There is not realistic way out of this for Japan, which means major trouble for the EWJ in the long term. The Japanese bond market has been quiescent, and yields remain ridiculously low given the macro risk that Japan presents. The Japanese 10-year yields a pitiful 0.6% — more than two full percentage points below the U.S. 10-year Treasury. This has been made possible because the Bank of Japan buys 70% of all Japanese government bonds, though it has resulted in a weaker yen.

Still, if I am right about Japan eventually having a sovereign debt meltdown, the yen’s declines of the past years will look almost quaint. The yen will effectively fall to zero.

That will make paying back Japan’s mountains of debt a lot easier, of course. But it will cause ordinary Japanese citizens — and particular its pensioners — a lot of pain.

If you want to trade Japanese equities, be my guest. Any asset, no matter how fragile its fundamentals, can be a decent short-term trade. But the real play here — and the one that I view as almost “risk free” over a longer time horizon — is shorting the yen.

As always, use common sense when trading. You can be “right” about a short and still lose a lot of money if you get caught on the wrong side of a short squeeze. An ETF option to consider in lieu of shorting the yen directly would be the ProShares Ultrashort Yen (NYSEARCA:YCS).

But if you’re still considering the EWJ, I’d point you to a duffel bag and a zippo lighter.

Disclaimer: This site is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results.

Source: Thinking About Buying Japanese Stocks? Let Me Get You A Duffel Bag, Some Gasoline, And A Lighter