Japanese Equities in 2016, A Look Back
In 2016 Japanese stocks went on a roller coaster ride as they entered a bear market (defined as being -20% from a recent peak) at one point, only to find themselves leading the global rally higher after the Trump election and managed to finish 2016 very slightly in positive territory. How does the stock market of a slow growth, sluggish and heavily regulated economy have such wild swings despite the underlying economy hardly changing? Although I will touch on that to some degree, that is not the main objective of this article. Rather, I am more interested in how investors can profit from such swings and specifically, what indicators or “clues” the investor should focus on during these swings.
However, before diving in, it is important to take a brief look back at some of the key events (both external and internal), which affected the Japanese equity market in 2016. The year began with great hope as the yen was weak (around 118 to the usd), tourism was booming and the stock market was still on a sugar high of the positive changes in corporate governance from the year before. However, starting in February the narrative for the global economy began to change as data out of China (Japan’s largest trading partner) began to show severe weakness. Unfortunately, this story continued to unfold throughout the entire year with the Chinese central bank weakening the yuan, which sparked a massive shot of yen buying.
Although the “China Syndrome” was a major theme for Japanese stocks this year, it certainly wasn’t the only one. For example, Japanese stock investors also had to contend with worries over US interest rate policies (the first rate hike was expected in June!), Brexit, PM Abe’s re-election, the BOJ’s own version of tapering and of course the US election in November. Overlaid on top of these events, were comments in the media from “the experts” to sell all your US stocks and that the bull market was very tired and a crash was right around the corner!
The purpose of looking back at some at some of the broad strokes of last year is simply to give perspective and I’m sure I’ve probably omitted a few events. The point here is that Japan is an extremely “noisy” market in that the main stock market indexes are heavily influenced by global macro factors due to its position as a large exporting nation. Thus, this is one of the key reasons why such a stodgy, developed economy can have such wild swings in its stock market!
With 2016’s macro and geopolitical events in mind, let’s take a deeper look at how the Nikkei actually traded. For all of 2016, there were 245 trading days and of those days, the market finished up on 128 days and finished lower on 117 days. Thus, there were only 11 more up days versus down days. On this point, I would just add that until the US presidential election, the stock market had roughly the same number of up days and down days!
Looking deeper at the data on the Nikkei index, it was interesting to find the longest consecutive winning streak was 9 days in a row, which occurred from early December to mid-December. However, during the period from Nov 10th to Nov 25th (right after the US election) the Nikkei index rose 9 out of 11 days with 1 very shallow selloff and 1 day where the market closed completely flat on the day.
The next longest winning streaks were for 6 days each and they occurred almost back to back at the end of June after Brexit and in the middle of July after the Japanese upper house election.
On the flip side, the NKY started off the year in January with a 6 day losing streak! There was also a 7 day losing streak at the end of March (China growth scare) and another 6 day losing streak at the end of April. However, since April, the longest consecutive losing streak for the NKY was 4 days, which took place in early June and early July. One possible reason for the drop off in losing streaks could be the fact that central banks had continued with easing measures during that time.
As I alluded to above, the Nikkei index also came within striking distance of entering the definition of an official bear market as defined as a drop of 20% or more from the yearly high. This occurred by using the high price of January 4th which was 18,450 and comparing to the low made after Brexit, which was 14,952. This constituted a -18.9% move for the Nikkei and for all intents and purposes was a nasty bear market that took down many long only managers as well as several hedge funds. Lastly, I would just note that for the entire year, the swing between the low in the Nikkei after Brexit and the highest price on the index for the year was an astounding +32% in six months!
Outside of the aforementioned winning and losing streaks, the Nikkei spent a good deal of the year “bouncing around.” The fact that Japanese stocks must digest macro data, political news and swings in the forex market can at times make the Nikkei seem like a manic depressive, where it rises one day only to fall the next. Thus in this type of environment a simple strategy of buying on down days and holding shares for just 1 or 2 days can actually provide consistent, but small profits when the market is mean reverting.
With all these statistics and facts about the Japanese equity market in mind, how can investors reliably identify when the market is trending (i.e. on a sustainable winning streak) and when the market is mean reverting and likely to be whipsawing? One of the best indicators I’ve found (completely by serendipity I might add!) is the number of stocks making new highs and the number of stocks making new lows. Typically, when the Nikkei begins a powerful upward thrust, the move higher will generally see a +1% rally or more on one of the first few days. This is in fact the most dangerous time of the rally because it often takes place after the market has been mean reverting and unfortunately there is no crystal ball to tell you that mean reversion trading has finished and trend trading has begun. However, one important clue to look for is how the new high list is behaving. That is, if the Nikkei has rallied for 3 days and the new high list is still well below 100 stocks, that is a signal NOT to commit capital just yet for trend trading. However, if the market continues to rally (even slowly) over the next several days and you see an expansion in the new high list from say, 40 stocks to 80 stocks, and then to 120 stocks, that is a very good signal to finish mean reversion trading and begin trend trading.
It is of course extremely important to track how the new high list behaves after it has surpassed 100 names and analyze it in conjunction with price, volume and momentum indicators on the Nikkei. During this time, the investor should be watching for a couple of things. First, can the market rally 1% or more on the 6th, 7th, and 8th days of the new uptrend. If yes, that is a very clear signal that bulls are committing large amounts of capital in anticipation of even higher prices. The most powerful moves higher that I have seen occur during this time and are accompanied by a total swelling of the new high list. For example, you might see the Nikkei gain +1.5% of on the 7th day of the rally and the new high list move from 150 names to 210. It’s also important to point out that on the correction days during the advance, you should NOT see large precipitous declines in both the Nikkei itself or the New High list. Should that occur, the best tactic is to stay long, but watch the moving averages for a crossover by the faster line down and through the slower line (I prefer to use the 13 & 26 dma, but any other days could work well too). One last point on the new high list is that it is also important to watch the quality of that list. In other words, are there many blue chip companies making new highs, or are they mostly smaller and less significant stocks to the entire economy. If you see a shift from high quality companies to smaller and less significant stocks, the chances of a precipitous drop in the new high list increases substantially.
I would now like to present two examples from 2016, one using the new high list and one using the new low list, to identify when to shift your trading strategy. First, let’s look at how the Nikkei traded at the very beginning of 2016. After being +9% for 2015, the Nikkei started off 2016 with a wave of selling, which saw the Nikkei fall for 6 consecutive days from January 4th (the first day of trading) until January 12th. During those six days the Nikkei lost 9.9%! Interestingly, on the last three days of that decline (Jan 7th, Jan 8th, & Jan 12th), the number of new lows began to expand exponentially. For instance, on Jan 7th, the number of new lows was only 89, but then quickly increased the next day to 163 and then exploded again on the following day to 317!! The very next day, the Nikkei rallied +2.8% and the number of new lows fell all the way back to 56! However, a lot of technical damage had already been done and a one day retreat in the number of new lows, was not enough to have you change shift strategy from trend to mean reversion just yet. Sure enough, the very next day the Nikkei dropped again (-2.6%) and the number of new low not only raced higher, but actually exceed the number two days before and hit 327 stocks! Thus, getting short the Nikkei index at that time was a proper entry point as the new low list expanded, corrected and then began to expand again! Thus, on Jan 14th, the Nikkei closed at 17,240 and had flashed a sell signal. The number of new lows stayed in triple digits for the subsequent trading days and actually hit a crescendo on January 21st as 772 stocks hit new lows while the Nikkei spiraled down to 16,017!!!!! Thus, if you shorted on the 14th and closed out on the 21st, the net profit was 7% for just six days’ worth of work!!! Moreover, you limited your exposed time in the market and captured a very workable trend. A traders dream for sure!!
The next example will look at the Nikkei’s price and the behavior of new high list during the US presidential election on Nov 8th. Due to the time difference between the US and Japan, the election results on Nov 8th were actually being reflected in live time on the Nikkei index during Wednesday, Nov 9th. As the result were coming in and it became clearer that Donald Trump was leading and may actually win, the Nikkei began to drop and then completely broke down by the end of trading and had lost -5.3% on the day!! Interestingly, on that day, the number of new lows increased from 21 the day prior to 103 and the new high list hardly moved as it inched down from 43 the day prior to the election to just 40 new highs on the day of the election. However, by the very next day bargain hunters and opportunist traders took the view that the previous day’s selloff had been overdone and the Nikkei rallied 6.7% and the number of new highs inched up to 66. Over the next several trading days, the Nikkei continued to climb higher, but he number of new highs still remained below 100 and thus didn’t quite confirm the “Trump Rally.” This changed though on Nov 18th, when the number of new highs actually expanded from 70 the day prior to 122. Thus, with new highs breaking above the 100 barrier, a buy signal was created on the Nikkei at 17,967. From this point, the Nikkei continued to dash higher as investors were brimming with optimism that a new Trump administration would lift regulations and cut taxes, which would then result in speedier GDP growth. In fact, from Nov 18th until the last trading day of the year on Dec 30th, the Nikkei gained +6.8% while number of news highs stayed above 100 for 24 of the next 25 days!! In fact, of the 5 days where the new high list contracted below 100, 4 of those instances occurred in the last six trading days of the year when the tape gets very thin because both domestic and foreign investors are away for Christmas and New New Year’s holidays. Therefore, there was really only one case on December 5th, when the New High list slipped below 100 as it dropped from 108 the day prior to 69 stocks. However, the very next day it shot back up to 148 stocks and stayed in triple digit until Dec 22nd when it dropped from 168 to 79 stocks. It’s important to note though, that even during the last 6 trading days of the year there was an alternating pattern of the new high list. For example, on Dec 22nd the number fell to 79 stocks as just mentioned, but the very next session (Dec 26th) it ran up to 105 stocks. The subsequent day (Dec 27) it dropped to 76 stocks, but then moved up to 126 stocks on Dec 28th. The final two days of the year saw the number of new highs fall back to 60 days and 54 days respectively. Lastly, I would just highlight one key difference between the first example in January and the second example in November and December. One of the key difference between these two trading trends was not only that one was an uptrend and one was a downtrend, but rather the time that it took each trend to develop. As I noted about the -7% drop in January, it took place over 7 days, while it took the Nikkei 29 days from mid-November to the end of December to capture roughly the same amount (+6.8%)! Needless to say, this point could be the topic of its own article by itself, but for our purposes, just know that stocks move faster on the way down than they do on the way up!
In sum, the Japanese stock market is an incredibly complex ecosystem that reacts with great sensitivity to the global financial system. As a result, the stock market in Japan is an extremely noisy market and is thus pre-disposed to being a mean reverting market. In fact, this is seen especially with domestic investors, whom are notorious for being very disciplined contrarian traders. This predisposition to mean reversion can provide substantial profit opportunities to courageous traders who are willing to buy on down days and sell on up days. On the flip side, the Nikkei can be a very streaky market at times and provide very fat profits for trend traders. Thus, being able to reliably identify if the market is trending or revering is crucial for Japanese traders and investors. As I hope I’ve demonstrated in this article, paying attention to the new high and new low list, at this point in time, is one of the most effective ways to gauge, which market environment you are facing.