Is the ‘Abe Trade’ Still in Play?

The votes have been counted.  Japan’s Liberal Democrats—the party of Prime Minister Shinzo Abe—won a landslide victory over the weekend, securing control of both houses of parliament.

The implications here are huge.  Abe is as close as you can get in modern Japan to a militant nationalist, and the win will only encourage him to escalate his war of words with China.  Abe is pushing for a re-write of Japan’s constitution that would scrap some of the pacifist language written in by the United States after Japan’s surrender in World War II.

All of that is fine and good, but the question on most investors’s minds is far more focused: what does this mean for Abenomics and the “Abe Trade” of going long Japanese equities and short the yen?

Japanese stocks were mostly flat after the news, suggesting that there were no real surprises.

Japan

Looking over the past few months, we get a more interesting story.  The Japanese Nikkei Index (orange line above) took a tumble in May and early June, falling into bear market territory.  Yet taking a lot of investors by surprise, the Nikkei has since rallied and gained back most of its losses.

The yen (green line), which has moved the opposite direction, rallied over the period before giving most of the gains back.

So, it would appear that the Abe Trade is back on…at least for the time being.

If you are a short-term trader or trend follower, then there may be a little money left to be made in this trade.  By all means, go for it. But be careful, and make sure you have some kind of risk management in place.

If you are a longer-term investor or if you are less-inclined to monitor your positions closely, stay out of Japan.  Being long Japan is comparable to picking up nickels in front of the proverbial steam roller.  If you linger too long, you will get crushed.

While I try to stay objective and avoid looking at the markets through biased eyes, I admit fully that I have become something of a Japan permabear.  When I look at the country’s macro environment, I do not see any set of circumstances whereby this doesn’t end poorly.  At 240% of GDP, Japan’s sovereign debts are the highest in the developed world, and by a wide margin.  Its population is aging and shrinking (see Jeff Reeves’ recent article about the Japanese boom in adult diaper sales) meaning its tax base to support its debts gets smaller every year.  And it adds to this mountain of debt with a budget deficit of nearly 10% of GDP.

All it would take for Japan to descend into a financial meltdown would be for its bond yields to rise by a couple percentage points…which is a virtual inevitability given the country’s borrowing needs.

And topping it off, after their torrid run, Japanese shares are no longer cheap.  The Nikkei trades for 16 times expected 2014 earnings.

When will Japan’s day of reckoning come?  Frankly, I have no idea.  It will come when investor sentiment shifts and investors suddenly perceive the risk that has been there all along.  It could happen tomorrow…or it could happen in a few years’ time.  But happen it will.

If you want to continue to play the Abe trade, the second half—shorting the yen—is the less risky option.  If I am correct about Japan eventually blowing up, then the yen will fall to zero…or close to it.

If you decide to play the first half—going long Japanese equities—do so with the mentality of a short-term trader and use proper risk management.  Japan is not a long-term buy because Japan has no long-term future.  If you need a reminder, print off Jeff’s article on Japanese adult diapers and tape it to your wall.

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