Is Japan a precursor of what’s to come?

Japan’s Nikkei 225 index, the broadest measure of blue chip stocks in Japan, fell more than 7% during the Thursday (i.e. Wednesday night in North America) trading session, providing investors with another data point evidencing the fickle nature of sentiment and perhaps, more importantly, the influential role of hedge funds in the short term price action on global markets.

There was some immediate follow through in Europe and a few hours later in North America when trading began on Thursday. However, by days end on Thursday, the US stock market was essentially flat, proving once again that bullish sentiment remains firmly in control.

Japan has been a major investing theme for hedge funds. It is the classic “don’t-fight-the-Fed” (i.e. Bank of Japan in this case) strategy where hedge funds have been aggressively buying Japanese stocks that will benefit from the liquidity being injected into the system by the Bank of Japan. The BOJ has been aggressively printing money since the third quarter 2012 in an effort to quell deflationary fears and stimulate domestic activity.

The other side of the trade – i.e. the hedge – has been to short the yen against most of the world’s major currencies. It has been a very successful trade over the past six months; a period in which Japanese stocks have rallied more than 70% and the yen has declined against most major currencies.

I suspect last Wednesday’s abrupt sell-off was related to a number of hedge funds unwinding Japanese bets in their typical herd mindset. Sharp price adjustments are to be expected when too many exit at exactly the same time.

The trigger was likely the not-so-subtle warnings that came out of the G-8 Finance Ministers meeting in Brussels the week before. I discussed this in the May 13th blog where I pointed to comments from US Treasury Secretary Jack Lew, who recognized that Japan has growth issues that need to be dealt with, warned that the world has limits on the degree to which it will allow Japan to stimulate its economy. In his words, “Japan had to stay within the bounds of international agreements to avoid competitive devaluations.”

Hedge fund managers who have been playing the Japanese theme since the beginning of the year probably wanted to take profits before world leaders take more serious action that could lead to a potential end game.

In my mind the “Japanese adjustment” has more relevance as a precursor of what to expect with global markets should the US Federal Reserve decide to “taper” their US $85 billion per month bond purchase program. To that end I noted the 2% intraday sell-off in the S&P 500 composite index that took place on Wednesday before the Japanese adjustment.

That swoon came about when newly released minutes from the Feds’ open market committee disclosed that some Governors would be willing to sign off on a tapering program that could begin as early as June. The markets quickly recovered when analysts discounted the minutes as being contrary to testimony by Fed Chairman Bernanke that the bond purchase program would remain in place well into 2014. But the price action is telling!

Drawing from the “what-we-think-we-know” file, I conclude that institutional investors, most notably hedge funds, continue to dictate daily trading patterns. These managers adopt similar themes, mostly momentum driven, and we know they tend to act in tandem. The relationship between cause and effect unleashes a rapid price adjustment that, at the wrong, could have serious repercussions.

Sharp short sell-offs are fine as long as bullish sentiment provides a so-called put option under the market. But that too is subject to sentiment shifts should any sell-off be seen as more than a pothole.

Make no mistake, after a four year rally even a minor correction could take stocks down 10% in a single trading session. Certainly a 10% pullback during a week is a distinct possibility. The problem is that it will come about when least expected. Most likely at a time when high profile analysts “talk up” the market with heightened expectations and when traders are exhibiting maximum complacency. Sound familiar!?

In my view, a good offense is dictated by a solid defense in the form of covered call strategies and perhaps long straddles on exchange traded funds that track US stocks (iShares S&P 500 Index Fund (CAD-Hedged), symbol XSP). Think of it as riding the surf while keeping a keen eye on the rocks that so often dot the shoreline.