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The Nikkei can still bounce back

The Nikkei 225, the most widely-quoted average of Japanese equities, has had something of a 25-year rollercoaster ride.

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It hit an all-time high in late December 1989, mostly on the back of the asset price bubble. The collapse lasted for more than a decade prior to bottoming in 2003 before the index descended (like all global indices) further again amid the global crisis of 2008.

Natural disaster sparked rout

The massive earthquake off the Pacific coast of Tohoku, north-east Japan, in March 2011 marked the beginning of a rout that saw the Nikkei drop throughout that year. While global indices also exhibited choppy behaviour, the safe-haven of the Japanese yen attracted a great deal of capital flow during equity market declines and thus helped to exacerbate the drop in the Japanese index.

Since Japan is the third largest national economy in the world and the fourth largest exporter, the Nikkei tends to benefit greatly from a weak currency. The price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange is heavily weighted towards exporting companies such as Toyota, Canon and Honda so the run upwards has been great news for investors. /

BoJ easing boosted Nikkei surge

Since November 2012 the Nikkei advance has outperformed most world equity markets, surging from 8950 to just shy of the 16,000 level on the promise and subsequent implementation of aggressive monetary easing from the Bank of Japan, in an effort to capture an inflation rate of 2% within two years. So this rally has in part been driven by recent weakness in the yen.

Interestingly, the foreign investor buying stocks directly would have seen profits flattered by the weak yen, with sterling appreciating almost 25% in total against the Asian currency. The 40%-plus year-to-date gains on the Nikkei are reduced substantially unless one removes FX risk by trading via spread betting.

Nikkei / GBP/JPY comparison chart (4 June 2013)

Correction or pullback opportunity?

The media-worthy plunges in the Nikkei over the past two weeks can be attributed to a number of catalysts. Confusing US Federal Reserve policy gave other equity markets the jitters, as the prospect of the market going it alone without the QE drug was digested. Volatility in the Japanese government bond (JGB) market had negative spillover effects too. Asian growth has also come under question as Chinese GDP forecasts and manufacturing output lose momentum. The question is whether or not we are seeing the beginning of an even deeper correction or does the pullback represent an opportunity?

From the highs of sub-16,000, the Nikkei has almost entered a bear market, with the welcome bounce on Tuesday of around 2% avoiding the prospect of the index losing 20% from its peak for now.

It was notable that the Nikkei futures market pulled back to touch the 200-month moving average – the market has not traded below that average since November 2007 – which makes this a significant support particularly as the average resides directly below the 38.2% retracement of the entire rally from November last year. This indicates a correction rather than a deeper reversal and doesn’t necessarily upset the bullish applecart. It may increase nervousness but is nonetheless a healthy development.

The highs seen this year did not manage a weekly close above the 15,596 level, which is the 76.4% Fibonacci retracement from the July 2007 highs to the October 2008 lows. The key level to break on the upside now is 13,920 – the 61.8% retracement of that same move.

Prime minister Shinzo Abe is set to reveal this week a third step of his ’Abenomics‘ growth strategy. It is expected to focus on the creation of special economic zones where deregulation and tax cuts can be implemented in limited geographic areas such as big cities. The government may also include steps encouraging Japan's public pension funds to increase their investment in equities and overseas.

It’s clear that despite the school being out out both domestically and globally on whether 2% inflation can be achieved in such a short timeframe, Abenomics will just keep trying. The upshot is that we are likely to see additional equity gains in both the near- and medium-term.

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