One of the most interesting market stories in the last week is the big drop in the Japanese stock market. Japan is the third-largest economy in the world, ranked by GDP. The values of the Japanese stock market, as measured by the Nikkei 225 index, dropped by 7.3% on May 23rd, and then suffered another fairly dramatic one-day decline of 3.2% on May 27th.
Over the last five sessions, the iShares MSCI Index ETF, EWJ, has dropped by almost 10% (see chart below).
Source: Yahoo! Finance
How could the market’s perception of the value of the world’s 3rd largest economy have dropped so much, so fast, in the absence of some kind of catastrophe or the emergence of some incredible revelation or change in outlook with regards to Japan’s economy.
The value of a stock, bond, or index of stocks or bonds, is determined by the market’s consensus view as to the value of future income that the investment provides. What has changed so dramatically in the last week or so is a shift in the consensus view rather than in some meaningful change in concrete measures of the Japanese market.
We may contrast this situation to the market decline after Japan suffered a catastrophic hit by a tsunami and earthquake in 2011. The impacts of this catastrophe included damage to nuclear power plants and other infrastructure, such that long-term economic impacts were unclear. In the first full day of trading after the tsunami, the Nikkei 225 dropped 6.2%. In this situation, the prospects for Japan’s economy were substantially impacted by an external event.
One plausible narrative in explaining the substantial and sudden drop in the Nikkei is based on exchange rates (see chart below). Japan’s economy depends heavily on exporting its goods, so a weakening currency will drive stock prices up because the country’s products are cheaper for its foreign consumers with a weak Yen.
EWJ rose 22.7% from the start of 2013 through May 21, as the Yen fell and then dropped dramatically in parallel with a sharp increase in the Yen on May 22. The drop in the Nikkei is out of all proportion to the increase in the Yen exchange rate, however.
To a large extent, I conclude that the sudden decline in the Japanese stock market is largely a result of behavioral effects and, perhaps, program trading that responds to notable volume levels. Market participants took an unusual drop in the Nikkei as a selling trigger, just as they amplified the gains in the Nikkei early in the year. In other words, we are seeing market participants trying to exploit momentum in both up and down directions speculating that the trend will continue.
The big picture lesson from the recent rapid drops in the Nikkei is that massive changes in price of even entire stock indexes, representing large portions of the global economy, can happen with startling speed, even in the absence of a clear driver when speculators play a large role in setting prices. Even as we look for causes of a big decline (or gain), we must recognize that major market moves can simply occur due to a confluence of behavioral drivers that may, in fact, have little demonstrable connection to fundamentals. Seeing the value of the world’s 3rd largest economy drop by almost 10% over five days, in the absence of a fundamental driver, should serve as a vivid warning as to how quickly the market’s “animal spirits” can shift.
- The Cost of Performance Chasing
- Being a Weather Contrarian
- Understanding France’s Credit Rating Downgrade
Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.