Japanese Stocks Swing to a Foreign Beat
Japanese stocks are possessed. At least it feels that way given their wild swings.
Traders in New York and London rub their eyes when they awake to see big moves overnight in Japan. The 4.2% drop last Tuesday in the benchmark Nikkei Stock Average was hardly unique. It has fallen or risen 3% or more in a day 16 times in the past year. The S&P 500, by contrast, hasn't moved that much once during that time.
That is the kind of drama that investors expect from Turkey, not the fourth-largest exchange by market capitalization in the world.
Japan has a stable government, a deep pool of institutional investors, free flow of capital and transparency. This is a formula for a liquid market that plunges only on remarkable occasions.
Yet the Japanese market's 30-day volatility, as measured by Thomson Reuters, is on par with emerging-market hotbeds Argentina and Thailand.
So what is behind all this to-ing and fro-ing? Blame a messy mix of feedback loops.
Japanese are a minority in their own market now, with overseas money accounting for nearly 60% of trades on the Tokyo Stock Exchange in January. A decade ago it was 35%.
That larger share of foreign investors may reflect that in 2013 Japan was among the best-performing stock exchanges globally, at least among developed markets. The Nikkei was up 57%, beating the S&P 500's 30% gain.
The catch is that for foreigners to take advantage of rising Japanese stocks, they have to short, or bet against, the yen. This is to prevent currency moves from erasing gains. Japan's biggest companies are exporters and book gains on foreign earnings when the yen falls. When it rises, the opposite occurs.
Tweak the yen, and stocks follow. Last week, fears that the U.S. recovery was losing steam sent U.S. bond yields lower. That reduced the difference, or spread, between Japanese and U.S. bonds. A narrower spread means that there is less incentive to hold dollars, so the yen rises.
Computer-programmed trading systems sense the yen rising and sell Japanese stocks, while also unwinding short yen trades. The cycle continues. Moreover, the increasing popularity of exchange-traded funds—especially among foreign investors desiring a quick, cost-effective way to dip into and out of foreign markets—likely exacerbates volatility.
The Bank of Japan and its monetary-easing program hangs over all this. More easing later this year, which many expect, should mean a weaker yen. That draws in more foreign investors, who made a ton betting on monetary easing in the U.S. and recognize a similar liquidity-driven opportunity. Similar to the U.S. in recent years, investors are tending to move together in a risk-on, risk-off fashion.
When will all this end? Getting Japanese pension, insurance and individual investors back into stocks would smooth the rough edges. They don't have yen trades to unwind. Seeing Japanese take more risks with their savings also would be proof that "Abenomics" really is working.
Until then, volatility rules.