Thinking of buying Japan on the dip? Steady yourself

Japanese stocks broke out of tailspin on Tuesday, but the prognosis isn't upbeat. The Nikkei 225 rose 2.1 per cent overnight, after falling more than 15 per cent in the previous eight trading sessions – an alarming downturn that shattered the best rally in a decade.

Since November, the Nikkei had risen 80 per cent by the third week of May, largely as an enthusiastic response to the country's new stimulus-heavy economic plan, dubbed Abenomics after Japan's new prime minister. Now, with stocks heading toward a bear market (defined as a drop of 20 per cent or more from a recent peak), this enthusiasm is drying up.

It's too early to declare whether Abenomics is working or not. Regardless, some commentators are struggling with the Nikkei's current height. Even after the recent decline, the index is up 63 per cent over the past 12 months, and stocks trade at a premium valuation of nearly 25-times earnings.

Deutsche Bank strategist Makoto Yamashita (via Business Insider) believes that the Nikkei will continue to correct for several months, if recent history is any indication. The index rallied between 2005 and 2006 on optimism about economic structural reforms, only to correct sharply. It then took eight months to recover to a new high.

"It is therefore natural to assume that the Nikkei Average will correct for several months even if it eventually rises above 16,000," the strategist said in a note. "Stocks could rebound faster this time given volatility is higher, but at least in June we see little chance of another rise in share prices."

Cullen Roche, who writes the Pragmatic Capitalism blog, wonders if the latest stock market correction merely conforms to so many other Nikkei corrections over the past two decades. The trouble with Abenomics, he suggests, is that it can't solve Japan's biggest structural problem: A declining population.

"Is it different this time?" he said. "Sure, when Abenomics solves the problem below [he's referring to a chart showing the population falling below 121 million in the next 20 years] then maybe it will be different this time ... Until then, Japan's problems continue to be structural and ones that government are unlikely to resolve through tough talk and QE."

In other words, if the Nikkei 225 is a buying opportunity right now, it is only for those with nerves of steel – or a stubborn contrarian nature.