The Japanese Nikkei 225 dropped over 1,100 points in what traders are calling either an overdue correction or a dire signal of things to come. The fall started in the afternoon session, ignited by weak Chinese data in the form of HSBC's May preliminary Purchasing Manager's Index, at a seven month low of 49.6. Another possibility brought up was that of the higher yields in play, up 7 basis points to a high of 0.955. These high yields were a source of concern for investors, as they hit levels that haven't been reached since April 5th of 2012.
During the Thursday session, words of reassurance came from Japanese Economy Akira Amari, saying that the "pace of the Nikkei’s rise recently was faster than expected." This points to a less dire situation as he tried to defuse fears that investors potentially faced as they watched the market drop over a thousand points, but it is a valid idea that needs to be fully fleshed out before the worries of the drop get out of hand. The Nikkei was one of the chief beneficiaries of the Japanese governments aggressive monetary policy as it was bolstered to an 81% gain since early October of last year, and its currency devalued by around 25%. This means that there were profits to be taken and as investors' confidence was being shaken in other areas of the world closing profitable long positions in the Japanese Nikkei secured them the cash that is indeed king.
Fears maintained throughout the day that the drop in the Nikkei 225 would change the psychology of the market, as only 10 times in the 50 or so year history of the Japanese Nikkei has it dropped by more than 7%. So, is it profit taking with a side of weak data? Or is it a negative implication of things to come?
On Wednesday, Bank of Japan Governor Haruhiko Kuroda acknowledged the volatile bond markets, but doesn't think they will have any lasting impact on the real domestic economy of Japan. The resulting 7.3% drop in the Nikkei 225 might have shaken his confidence, but as the new day's session begins as of this writing, stocks are back up 2.7% since the opening bell. This revival in the confidence of the Nikkei will be tested in the upcoming hours, but time will tell in the end whether investors were truly just taking profits or have taken this drop to heart, becoming ever more wary of the Nikkei.
The true test of the global confidence will not likely be shown in the performance of the US stocks (as the QE crutch is still going strong) but rather in developing countries and their respective currencies. A few currencies that were dragged into the mess Thursday were developing nations' currencies such as the Mexican peso, the Turkish lira and the Phillipine peso.
In short, the drop in the Nikkei is testament to the dangers of buying into established rallies, as profit taking becomes a viable source of income for investors hurting in other areas of the world. As for the fears of a US market crash, we are in fact due for a correction. When is anyone's guess. If you want to know the probability, however, according to Josh Brown, history suggests an average of three 5% pullbacks a year, one 10% correction each year, and a 20% sell-off every three and a half years. Additionally, "The fact that we haven’t had so much as three or more down days linked together since December of 2012 and nary a 2% decline year-to-date, I suppose the optimal thing would be to go lower and get that out of the way. The predominant bear case of late has been the absence of a correction and the overbought readings of every sector".
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