3 Reasons Why Cheap Japanese Stocks and a Strong Yen Won't Last

Includes: FXY, YCS
by: Lou Basenese

Japanese stocks currently rest at historically cheap valuations. On the flip side, however, the Japanese yen is sitting near historic highs. It’s a situation that poses a serious threat to your profitability – as I warned last week.

Cheap stocks set against a strong yen simply don’t mix. Why? Simply put, because Japan is such an export-driven economy. So if the yen appreciates, it makes the country’s products less affordable to foreigners, thereby reducing sales and reducing economic output. By contrast, when the yen depreciates it boosts exports, as Japan’s products become more affordable to foreigners.

A current WisdomTree Research report underscores this reality, too. Over the last three years, Japan represents the only developed country that exhibits a rare negative correlation with its currency. When the yen drops, Japanese stocks rise -- and vice-versa.

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Of course, nobody on Wall Street wants to freely share this information, but it’s important that you understand it if you own (or want to own) Japanese stocks. A weaker yen threatens to undercut any gains in Japanese stock prices – and a weaker yen is exactly what’s in store.

Here’s why – and three ways to guard against it.

A Yen Tug of War

In the short-term, the yen is likely to trade in a tight range. I say that because two powerful forces are currently at work:

  • Domestic Disaster Relief: On one hand, countless Japanese citizens and corporations are repatriating their assets to help fund the rebuilding efforts. They’re literally buying yen, boosting its value. And with rebuilding estimates in Japan now above $300 billion, we’re talking about a serious amount of buying, too.
  • Global Currency Intervention: On the other hand, however, the Bank of Japan (and governments around the world) is intervening and selling yen. It recognizes Japan’s reliance on exports and the disastrous dent that a strong yen would have on the country’s economy in the aftermath of the earthquake, tsunami and nuclear crisis.

As Japan’s Finance Minister Yoshihiko Noda said about the recent intervention, “First, we agreed on joint intervention on March 18 and based on that agreement, we put language in the statement saying, ‘We will monitor exchange markets closely and will cooperate as appropriate.’”

Translation: We’re in a tug of war against repatriation efforts and we’re going to intervene as much as necessary to keep the yen from appreciating sharply.

And the government promises to prevail. After all, it’s the only player with the ability to print money. In essence, its strength and endurance is unlimited in this currency battle. And once the battle subsides, the fundamentals also point to a weaker yen.

The Three “D’s” of a Yen Devaluation

While everyone is screaming from the rooftops about the United States’ debt burden, Japan is the heavyweight champion of bloated debt and deficits. Let’s look at its perilous “Three D’s” of yen devaluation:

1. Debt: Over the past 25 years, debt issuance in Japan has quintupled. Debt levels now rest close to 200% of the country’s GDP.

2. Deficit: Meanwhile, the government has engaged in deficit spending of about 5% to 7% each year for the last 20 years. Even the International Monetary Fund recognizes the problem. In February, IMF deputy managing-director Naoyuki Shinohara said, “If you look at Japan’s outstanding debts and fiscal deficits, they’re not sustainable over the medium- and long-term.”

But in the aftermath of the earthquake, Japan is going to have to issue even more debt and run even higher deficits. And the real problem comes to light when you consider Japan’s demographics.

3. Demographics: Up to now, Japan has got away with paying paltry interest rates on its debt because Japanese citizens have been the only buyers. Historically, they’ve bought 95% of all Japanese government debt. But in the future, that can’t happen anymore.

Much like America, Japan is graying. The first baby boomer is set to retire next year. And as the retirement masses swell, more Japanese are going to switch from buying Japanese bonds to save for retirement to selling Japanese bonds to fund retirement.

In fact, the transition is already afoot. Japan’s Government Pension Investment Fund (GPIF) said it’s going to become a net seller of bonds. Last September, the fund, which is the world’s largest, forecast that it would need to sell four trillion yen in assets in order to fund payouts in the current fiscal year.

Keep in mind, the GPIF has been one of the biggest buyers of Japanese debt. Now it’s a seller. That’s bad news for the yen.

Finding new buyers for debt promises to be a long-term threat to the Japanese economy and the value of the yen. Increasing interest rates is one option. But given Japan’s already enormous debt burden and deficit, it would also mean increasing interest expenses. And that means Japan would need to issue even more debt to cover its increasing costs.

Talk about a vicious cycle.

What’s Good for Japanese Stocks Isn’t Always Good for Investors

Either way you slice it, debt, deficits and demographics promise to weigh on the yen in the months and years ahead. While a depreciating currency might bode well for stock prices in Japan, based on historical correlations, it’s bad news for investors.

If you’re buying Japanese stocks right now, Wall Street might not advocate it, but I certainly am. Hedge your currency exposure. Or be prepared to forgo a significant portion of your profits.

Here are three options to consider:

  • Sell short or buy put options on the Rydex CurrencyShares Japanese Yen Trust (NYSEARCA:FXY).
  • Purchase an inverse fund like the ProShares UltraShort Yen (NYSEARCA:YCS).
  • Buy a Japan fund that’s currency neutral, whereby the managers actively hedge the currency exposure for investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.