The reason why I’m now bearish in the short term on Japanese shares

Greetings from London. It is cold here, and I can see my breath. Importantly, unlike in Bangkok, you can’t buy grilled chicken here on a street corner.

The reason why I’m now bearish in the short term on Japanese shares:

In the FT a few days ago, there was an article talking about what I have been saying for a long time. Namely, that domestic participation is a whole new leg to the market. However, reading the other parts of the paper also reminded my subconscious of a new thesis I have been slowly cooking, and is now ready.

The thesis goes like this          

(1) The Japanese rally to date has been mostly driven by Fx

(2) We have been in a large global risk rally, and this is worrying because:

(2) a. Global sentiment is at alarm-bell levels

(2) b. Stocks keep on going up while every indicator of economic activity seems to be going down, particularly my favorite kinds of indicator – things like Wal-Mart

(2) c. I am not finding almost any candidates to buy outside Japan, and within Japan there have been significant moves up in stocks which should not benefit from recent developments.

(3) A lot of the rise in Japanese shares is due to foreign buying.

(4) The situation with the central bank in Japan is not as easy as it appeared initially, partly due to internal resistance, partly due to external pressure.

(5) Other countries want to cheapen their currencies too.

The setup in (1)-(3) has exacerbated the drop in the yen. The reason is that foreign buyers hedge their currency risk, applying pressure on the yen at the margin. There has been also a significant amount of outright bets against the yen. Since this is a self-reinforcing dynamic, when the yen and stocks start to reverse a bit, the drop will be worse than otherwise, as the self-reinforcing cycle moves in the other direction.

That’s it. In other words, I feel there is too much stinking optimism globally, this will reverse, bringing down Japanese stocks and pushing up the yen, which will a cause synergistic gravitational pull on the stocks.

I have been reducing positions significantly, but am still slightly long. I am not planning to short Japanese shares now, but if I were to do so the prime candidates would be big electronics manufacturers. I may short the index to get the right exposure while keeping hold of illiquid names.