Is this a secret indicator for US markets?

Talking Numbers

Another country's market has been trading closely with the S&P 500. And, it's up 2% in the past week.

The Japanese stock market is up over 2% in the past week on a lower yen and higher exports. Now it’s getting closer to its May peak.

What’s of interest to note is that the US stock market is highly correlated to Japan’s. The S&P 500 and the Nikkei 225 indices had a correlation coefficient of 0.84 for the year ending October 31. That means there’s a very strong relationship between the two (The closer a correlation coefficient gets to 1.0, the closer the relationship).

Does that mean the Nikkei could be used as a secret indicator for the US markets? And, if so, are recent gains a good sign?

“There’s a good reason for them to continue to move together and that’s central bank policy,” says John Stephenson, portfolio manager at First Asset Investment Management. “If you look at what’s happening in Japan, the scale of their quantitative easing is three times on a per-GDP basis than what is happening here in the US. I think that’s what’s really driving it.”

Stephenson is referring to the policy of both the Bank of Japan and the US Federal Reserve Bank to buy bonds in their respective countries. Known as “quantitative easing”, it not only lowers interest rates (as bond yields move inversely to price as the bonds get bid up) but also adds money into their countries’ financial system. In the United States, the Fed buys $85 billion in US Treasury and mortgage bonds. In Japan, the BoJ now buys ¥7 trillion ($70.2 billion) of bonds every month. However, Japan’s GDP is only 38% the size of the GDP in the United States.

(Watch: Ex-Fed official: 'I'm sorry for QE')

Yet there’s another correlation between the two countries that has an effect on the Japanese market.

“The real correlation is between the Nikkei and the 10-year bond yields in the US,” says Stephenson. “We saw a very strong (negative) correlation in the first part of the year. It sort of broke down when started talking taper (of US quantitative easing) in May. Now, it’s starting to reignite again.”

As for the relationship between the Nikkei and the S&P, Talking Numbers contributor Richard Ross, Global Technical Strategist at Auerbach Grayson, sees a possible bullish chart– for the Nikkei.

“That correlation between the Nikkei and S&P has been extremely strong throughout 2013,” says Ross. “However, that correlation has started to break down in the last six weeks.”

(Watch: Jack Lew: US is leading world in economic recovery)

For Ross, who sees the potential for a correction in the US markets, a divergence between the two indices could be a good thing. For the Nikkei to be bullish, though, it will have to break above a key resistance level.

To see what level Ross believes the Nikkei must break above to be bullish and to see the rest of Stephenson’s take on the US and Japanese markets, watch the video above.

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