The following is a reprint of the market commentary from the June edition of The Option Advisor, published on May 24. Prices and the charts were taken midday on May 24. For more information or to subscribe to The Option Advisor, click here.
The performance of the major stock markets around the world can diverge significantly. For example, as of the close on Thursday, May 23, the 2013 returns (excluding dividends) for the stock markets of Japan, Europe and the U.S. stacked up as follows:
Japan (Nikkei 225): +39.3%
Europe (Euro STOXX 50): +5.7%
U.S. (S&P 500): +15.7%
You probably recall the financial crisis that swept through Europe in the first half of 2012 and went on to adversely impact all the key world stock markets, but you are likely not aware that the early warning signs for U.S. investors in March 2012 of bumps in the road ahead were most evident from the pricing of volatility across the Atlantic. Specifically, from mid-March through April 4, 2012, the Euro STOXX 50 volatility index popped from low to high by 60% (from 17.26 to 27.52), while our CBOE Volatility Index (VIX) rose from 13.66 to 17.74 (for a less-than-unusual 30% gain).
And concurrent with this period of soaring volatility in Europe, the S&P had barely budged -- declining by 4 points from 1,402 to 1,398. In fact, the S&P had achieved a new 2012 high of 1,422 on April 2. But by June 4 -- just two months later -- the S&P had declined by 11% to 1,266.
My point is that "gains may vary" among the various markets around the world, and this is neither good nor bad but is rather a simple fact of life. But when volatility rises substantially in any major world market, U.S. investors are well advised to pay attention to this as a potential call to action to decrease their equity exposure. Why? Because heightened volatility and its first cousin -- the sharp market pullback -- can be quite contagious if "critical mass" is achieved.
On Thursday, May 23, the heretofore relentless 2013 rally in Japan's Nikkei 225 Index approached yet another milestone (the 16,000 level, not very long after toppling the 14,000 and 15,000 levels). But there was to be no new milestone achieved on May 23. Instead, there was a furious 10% intraday correction that carried the Nikkei below 15,000 by the close. And then after an unsuccessful re-test of 15,000 early in Friday's session, the Nikkei proceeded to trade down to just below 14,000 before rallying to close marginally higher at 14,612.
And when the dust settled on this week's trading, the Nikkei's peak closing price on Wednesday registered a year-to-date gain of 50.3% (see the accompanying chart -- click to enlarge). Consistent readers of this space are well aware of my strong belief that round-number gains and losses over common benchmark periods (such as year-to-date) often act as short-term resistance (or support), and in some cases can define major tops (or bottoms).
Another concern about Japan from a technical perspective relates to the iShares MSCI Japan Index (EWJ), the most popularly traded proxy in the U.S. for the Japan market. Per the accompanying chart (click to enlarge), EWJ closed below its 40-day moving average on May 23 for the first time since the rally off the December lows took hold, and is now flirting with its more widely followed 50-day moving average.
But technical concerns do not always translate into market breakdowns, and even if a breakdown of some magnitude did occur in the Japan market, it is open to question whether this would have a material negative impact on U.S. equities. Of much greater concern to me is the huge pop in EWJ implied volatility that has accompanied the price weakness. According to Trade Alert, 30-day at-the-money implied volatility for EWJ stood at 19.8% at the close on May 22 and then soared to 31.6% by May 23.
If this volatility spike turns out to be a "one and done" affair and if EWJ volatility begins to drift back toward the 20 level, I would not be inclined to temper my bullish outlook on U.S. equities. For now, the fact that implied volatility on the Japan market has proven capable of such a sudden surge should at least give pause to consideration of the sustainability of the unusually stable state of the U.S. market, the calm of which may be subject to major degradation with little notice.
In general terms, I see the operative question at this point to be whether fallout from a significant Nikkei correction can sidetrack the U.S. market rally in 2013, just as fallout from weak European markets sidetracked the 2012 U.S. market. But I see this issue as defined much more in terms of whether or not abnormally high volatility in Japan in recent days proves to be aberrant, as opposed to whether or not the stock market in Japan experiences a significant correction after its blowout performance in the first half of 2013 compared to other world markets.
The Case for Big Moves in IWM and QQQ
Featured Partners: AOL DailyFinance
© 2014 Schaeffer's Investment Research, Inc. 5151 Pfeiffer Road, Suite 250, Cincinnati, Ohio 45242
Phone: (800) 448-2080 FAX: (513) 589-3810 Int'l Callers: (513) 589-3800 Email: firstname.lastname@example.org
All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.
Market Data provided by QuoteMedia.com | Data delayed 15-20 minutes unless otherwise indicated.