One of the hottest trades in the world this year has been Japan.
Short the yen, buy Japanese stocks. It’s practically become conventional wisdom.
In fact, Japanese equities were basically the hottest major asset class in the entire world before today’s bloodbath, posting 20.9% cumulative gains over the past three months alone.
Last night, though, sparked by the first notable sell-off in three weeks in American stock markets – and really driven home by new data overnight that revealed the Chinese manufacturing sector has unexpectedly dipped into contraction – the Nikkei 225 plummeted 7.3%, marking its biggest single-day drop since the earthquake that ravaged Japan two years ago.
That takes the Nikkei back to levels not seen since May 9 (it’s been moving quickly on the way up).
At least one analyst finds the drop-off in Japan reminiscent of the Lehman Brothers collapse in 2008 that unleashed turmoil on markets.
“Lehman-like in Japan,” writes Société Générale foreign exchange strategist Sebastien Galy in an email this morning.
“Volatility in the [Japanese government bond] futures market forced the [Bank of Japan] to step in, if some sources are to be believed,” says Galy. “More broadly the carry trade built up over the past few months is unwinding as VaR management systems kick in with higher volatility, expect rising margin calls and the likes.”
In February, when we solicited our favourite analysts for the charts that worried them most, Phoenix Partners Group Chief Equities Strategist Michael Block told us, “The Japanese 5-year iTRAXX CDS spread has come screaming tighter as bullish euphoria has taken hold in Japanese stocks and credit. When this miracle has a blip, a lot of folks long credit (including ones who are long structured products that are short these CDS and indices) are going to feel pain…and guess what?? The same folks are also short yen…long U.S. stocks…you get the picture. CORRELATION WILL BE THE DEATH OF US AGAIN.”
In a note, Société Générale cross-asset strategists point out that hedge funds have already begun winding down their positions in Japanese stocks after a big build-up this year.
The charts above also highlight the fact that after the dizzying run of the past few months, the Japanese stock market has returned all the way to the highs seen in 2006.
In a note to clients written last night before the release of the ugly China manufacturing data, Mitsubishi UFJ Morgan Stanley Chief Technical Analyst Naohiko Miyata mused on the high levels of Japanese stocks as well, warning that a big correction could be forthcoming:
We think the wave count shown in Figure 2 is appropriate for the rise in the TOPIX index that began from 692.18 in June 2012. The advance beginning from 971.33 in April 2013 can be counted as wave 5, and once this wave runs its course we think ascending wave (1) running from June 2012 will be completed.
In calculating the wave 5 upside target, one classical approach says that the rise from wave 1 to wave 3 and the subsequent rise to wave 5 form a golden ratio.
We try applying this principle to the TOPIX. There was a 369.57pt advance from wave 1 to wave 3, and 61.8% of this figure is 228.39pt. Adding this result to the wave 3 high of 1,061.75, we get a wave 5 upside target of 1,290.14, which corresponds well with the high of 1,289.77 in morning trading today (May 23).
TOPIX could enter wave (2) correction
As of this writing during morning trading on May 23, we are not especially confident that a correction is about to begin simply because the USD-basis Nikkei average and the TOPIX have reached milestones. However corrective wave (2) is poised to begin once wave 5 within wave (1) comes to an end, and we assume this will be the largest correction since June 2012. The “first act” of the so-called Abenomics market may be coming to an end, and we think movements in the near term need to be watched closely.
The yen is up 1.75% against the dollar this morning. Japanese 10-year bond yields rose 11.5 basis points to 1% overnight, marking the highest bond yields since April 2012. European markets are heavy in the red across the board. In the United States, futures point to a 1% drop when markets open.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.