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Greece and the EU may be getting all the headlines these days, but I believe you should also stay away from another developed market: Japan. Last year, I was positive on Japan, but the passage of time has made me have a change of heart. I have five main reasons you may want to stay away.
1. Japan sports the highest government-debt-to-GDP ratio in the developed world.
Approaching 200%, the Japanese government is twice as irresponsible as the U.S. government, as its economy has shrunk to its 1991 size. We now have two lost decades in Japan, and the fundamental picture has noticeably worsened in the past 20 years.
2. The Japanese population is declining.
Japan has a population of 127 million people, and many of those are rapidly aging. The country's total population is projected to continue to decline for decades if demographic trends don't change. An older population means more government expenditures and less tax revenue, which is one of the reasons for the exploding deficit mentioned earlier.
Such demographic trends are very hard to reverse, which is why a shrinking population becomes the hourglass of the inevitable fiscal crisis. Immigration reform that would make it easy for foreigners to settle in the country could help solve such a problem, but a good part of Japanese society seems to resent the idea.
3. Household and national savings rates are declining noticeably.
Japan has been running trade surpluses for a long time, thus providing the country with a very high national savings rate. Japanese multinationals Toyota (NYSE: TM ) , Nissan (Nasdaq: NSANY ) , Honda (NYSE: HMC ) , and Hitachi (NYSE: HIT ) -- more on them below -- are some of the most competitive globally, which is why there is a perennial trade surplus. So far, government deficits are being financed out of those savings. As the population has aged, the household savings rate has declined from the low 20% to the upper single digits, and it's likely to get worse. The government now has to finance bigger deficits with smaller savings.
4. Deflation is still a very big problem crippling the financial system.
Ongoing deflation despite a more aggressive Bank of Japan has put the financial system in a bad shape. In a deflationary environment, the value of bank collateral (assets pledged by borrowers) falls while debts remain constant, generating losses for banks.
5. Deflation may flip into out of control inflation.
The growing government deficit and debt burden will make it impossible for the Japanese government to pay interest on its debts. That's especially the case if interest rates rise due to crowding-out effects of deficit spending and aggressive monetization efforts by the Bank of Japan.
Now, all those concerns laid out, I should say that I believe in Toyota, Nissan, Honda, and Hitachi. Leaving aside Toyota's recent troubles, these companies are well-operated and, as multinationals, aren't tethered to the Japanese consumer.
But these five weaknesses should tell you that a buy-and-hold strategy that has miserably failed in the past 20 years in Japan should be avoided. And any smaller domestic-demand-driven companies should be avoided -- especially after a big rally similar to the one we have just had -- as well as exchange-traded funds (ETFs) that follow the main indexes. (I'm talking about you, iShares MSCI Japan Index (NYSE: EWJ ) .)
To sum it up: Rallies in Japanese stocks are for renting, not owning. Japan could well be the place where the first sovereign debt crisis in a major industrialized country happens.
More on market issues:
- EU Bailout: TARP on Steroids (Fool TV)
- The Best Investing Ideas in Basic Materials
- Are BRIC Countries a Threat to the Dollar Standard?