Why Nikkei Sell-Off May Foreshadow Things to Come

Why Nikkei Sell-Off May Foreshadow Things to ComeThe one-day sell-off last week in Japan’s equities market with the benchmark Nikkei 225 plummeting more than seven percent in one day should not be ignored; in fact, the drop may be a harbinger of things to come. I don’t have a crystal ball, but my market sense is tingling.

The reality is that the sell-off in the equities market was not a surprise, given that the Nikkei has advanced 70% over the past six months. And this advance was driven largely by Prime Minister Shinzo Abe’s aggressive 10-year stimulus strategy to jumpstart the dormant Japanese economy.

Yet what was more concerning was the lack of a follow-through by the Nikkei equities market after the sell-off, as the index rallied a mere 0.9% the following day.

Nikkei equities market

Chart courtesy of www.StockCharts.com

The market’s fear is that if the selling continues on the Nikkei, this could drive down confidence in the equities market and trigger deeper losses on the horizon, including declines in domestic trading.

The Japanese equities market could easily go lower, given the advance so far.

For Prime Minister Abe, should the Japanese equities market reverse course and decline, the move would likely erode confidence in Japan and test Abe and the country’s resolve.

In my view, as I have discussed in these pages in my previous commentary on Japan (read “Japan Not Home-Free Despite Strong GDP”), the country’s aggressive fiscal and monetary policy is not a sure bet to get Japan out of its economic abyss.

In fact, the aggressive printing of money in Japan will create a bloated national debt level on the country’s balance sheet, which is already one of the weakest in the world.

The ability to drive the economy by spending trillions may work in the upcoming years, but I wouldn’t feel good about amassing the amount of debt that Japan is.

The sell-off in the Nikkei equities market could make investors uneasy on this side of the Pacific.

Domestically, the market is concerned about the Federal Reserve looking at a possible reduction of its bond-buying program as early as June during the Federal Open Market Committee (FOMC) meeting that is scheduled for that month.

The fear is that more selling in the Nikkei equities market may trigger deeper losses to come not only in Japan, but elsewhere; so there may be some apprehension to jump into stocks at this point.

The chart of the S&P 500 below suggests that a possible correction may be in the works, as shown by the ovals. Note also that in 2012, the S&P 500 gained a mere seven points from May 1 to October 31—historically the weakest six months for stocks, according to the Stock Trader’s Almanac—but advanced 13.4% for the year, so we could be headed for some slack.

S&P 500 chart

Chart courtesy of www.StockCharts.com

I would want to see a bigger sell-off here before considering injecting new capital into stocks.

Again, while the advance has been financially rewarding, I still feel a correction is on the horizon. A big sell-off could be an opportunity to buy.