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Why it could get a lot worse for stocks

Why it could get a lot worse for stocks

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For much of the last six months, the benchmark indices for the US and Japan traveled a together; the S&P 500 and the Nikkei 225 moved in the same direction about 65% of the time. Now, with recent declines in the Nikkei– down 9.6% since the start of 2014 – does that mean investors in the S&P 500 and US stocks in general should be worried?

A look at the relationship between these two indices in the recent past may give some idea about just how significant, if at all, the Nikkei may be in determining the S&P 500's next move.

(Read: Asia stocks fall on China PMI; Nikkei closes at 2-1/2 month low)

Over much of the previous two decades, the S&P 500 and the Nikkei usually had a correlation coefficient of less than 0.56 (based on monthly return over five year periods), though the two indices had a generally positive relationship.

Then the worldwide financial crisis happened.

From October 2008 until August 2011, the two indices had a correlation coefficient above 0.70, meaning the two had a very strong positive relationship. It has since dropped to 0.61 as of October 2012, in part because the huge effects of the crisis were no longer part of the equation (The Nikkei was down 42% while the S&P 500 lost 38% in 2008). Part of why the correlation is down is also because the S&P 500 was flat or up every year since 2009 while the Nikkei was down in 2010 and 2011.

Then, with large amounts of monetary stimulus (“quantitative easing”) in both the US and Japan, stocks in both countries saw phenomenal returns. The S&P 500 was up 29% in 2013 while the Nikkei had made investors over 56% that same year.

So, with the Nikkei down thus far in 2014 – in part due to tapering of the monetary stimulus in the US and worries over Chinese growth – is that a secret sign that US stocks are headed down, too?

Not necessarily, says CNBC contributor Andrew Busch, editor and publisher of The Busch Update.

“When a stock market is up over 50% in one year,” says Busch of the Nikkei, “you’re ripe for a pullback and a pretty aggressive one.”

The next two months will relatively rough for stocks, says Busch.

“I think the first quarter is going to be challenging for all of these markets,” says Busch. “You don’t have a new story about faster growth or more quantitative easing or anything like that. You’ll have to back to earnings and really see growth in companies’ revenues and profits.”

(Read: Wall Street looks to January's ISM report; futures mildly higher)

Steve Cortes, founder of Veracruz TJM, believes that trying to predict the US market by looking at the Nikkei isn’t such a great idea.  

“When the second biggest stock market in the world gets hit hard, it is concerning,” says Cortes. “But, ‘Turning Japanese’ was a terrible song by the Vapors many years ago and it’s a bad thesis right now.”

[Editor’s note: The Vapors were incredibly underrated.]

Cortes disagrees with those that say that the United States is headed for the kind of stagnation and deflation faced by Japan until recently due to demographic differences between the two countries.

“By the middle of this century, Japan will have lost population,” says Cortes. “The United States, because of a higher birth rate and immigration, will add 100 million people. So, we are very, very different from Japan. There might be many other valid reasons to be concerned about the S&P 500 but Japan is not one of them right now.”

To see the rest of the discussion on whether Japanese stocks are a warning for the US, watch the video above.

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