DEUTSCHE BANK: We Don't See A Bottom In Japanese Stocks — Should Correct For Several Months

japanese nikkei 225

The Japanese Nikkei 225 has corrected a staggering 15% since just May 22.

As a result, one of the world’s hottest stock markets is suddenly flirting with “bear market” territory – defined as a 20% price decline from the market’s previous peak.

In his latest note to clients, Deutsche Bank strategist Makoto Yamashita cautions that “we do not see a bottom,” and says it is “natural to assume that the Nikkei Average will correct for several months.”

The good news, says Yamashita, is that a range-bound Nikkei will help to reduce the volatility in the Japanese government bond market that has been cause for concern in the marketplace as of late.

Yamashita writes:

The Nikkei Average fell to below 14,000, and we do not see a bottom. It has fallen 17% from the recent peak of 15,942 on 23 May. This is an extremely large fall for just under two weeks. Many investors likely still see this as a healthy correction since the Nikkei Average had nearly doubled over the six months since November when it was above 8,000. That said, normally we would expect it to take some time for the Nikkei Average to pass 16,000. Japanese stocks also saw a large correction after rising sharply in 2005-2006. The Nikkei Average rose from below 12,000 in August 2005 to above 17,500 in April 2006 due to expectations of progress in structural reforms after then-PM Junichiro Koizumi called a snap election on postal reform. The index corrected sharply in June 2006 to around 14,000 then rose to above 17,500 through end- 2006. However, it took eight months for stocks to exceed their previous peak after bottoming.

It is therefore natural to assume that the Nikkei Average will correct for several months even if it eventually rises above 16,000. 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. A range-bound Nikkei Average would help to reduce volatility in JGBs. Gross potential buying pressure will become relatively large compared to coupon-bearing JGB issuance with supply/demand in June impacted by the BoJ’s more flexible JGB purchases and large JGB redemptions. Conditions for a fall JGB yield volatility are coming together. UST yields remain a source of volatility, but we believe the risk of a sharp rise in yields has diminished given the deterioration in yesterday’s US ISM index.

The Nikkei finally stanched the bleeding today – rising 2.1% – but if Yamashita is correct, the wild price gains that have made Japanese stocks one of the hottest trades of 2013 may pause for a while going forward.

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