Market optimism has been largely generated by the monetary easing programs spearheaded by newly installed Prime Minister Shinzo Abe, but a recent surge in volatility and some of the biggest single-day price declines in two years signal a major turn in sentiment. The Japanese stock index has fallen 17% from its five-year peak reached May 23 but there is little to suggest that we have yet to see the final lows for the year.
Bear markets are typically defined as any drop of 20% from a significant price high, so this latest activity in the Nikkei marks one of the most notable turns in sentiment the markets have experienced this year. Japanese stocks have not seen volatility this extreme since the Tohoku earthquake and tsunami devastated major areas of the the country's economy in 2011. This volatility has been largely attributed to weak economic data from China, upward pressure in government bond yields and possible reductions in quantitative easing stimulus from the Federal Reserve.
But the main question is whether these changes suggest growing disbelief that Japan's stimulus programs will provide sustainable growth in the long run.
While it can be argued that short-term volatility has been driven by external factors, outlook for the bigger picture rests on the aggressive central bank policy measures implemented earlier this year. In an attempt to drive growth after decades of economic stagnation, the Bank of Japan , has enacted programs to buy long-term government bonds (bringing down interest rates), and to double the active money supply (encouraging consumer spending). The BoJ hopes that combining low borrowing costs and larger amounts of available cash will increase spending at both the business and consumer levels, propel domestic consumption and bring inflation closer to its normalized target of 2%.
The initial market reaction to these programs was to buy Japanese stocks (in particular, export companies) and to sell the yen. Against the U.S. dollar, the yen has seen declines of almost 30% since last November.
A weak currency benefits Japanese exporters on multiple fronts: Prices become more attractive to foreign consumers and companies are able to magnify profits once foreign earnings are repatriated. Broad optimism for a continued global recovery has been viewed in conjunction with improved earnings prospects for the country's exports.
The result has been a massive rally in the Nikkei 225, but with stock valuations holding well above their near-term averages, it is not entirely surprising to see investors book profits -- especially with declining economic data in China and an end to stimulus programs in the U.S. making recent rallies in the Nikkei 225 vulnerable, as additional downside corrections become more likely.
Those looking for exposure in Japanese stocks should take note of the fact that volatility in these markets is not entirely uncommon. In the past few decades, we have seen several bull markets end with steep declines - with some of the most recent examples occurring under the watch of Prime Minister Junichiro Koizumi.
The declines seen in recent weeks were driven largely by both Japanese institutions and individual investors. These groups were net sellers of regional stocks, cashing in nearly 8 trillion yen ($80 billion) in equities from November through May. Conversely, foreign investors (both at the short-term and hedge fund levels) generated the initial rally. Foreign investors were heavy net buyers, purchasing nearly 10 trillion yen ($100 billion) in stocks and adding a good deal of positive momentum.
Given these major price fluctuations, investors with low risk tolerance will likely opt to stay on the sidelines until stocks show signs of stabilizing. Sentiment will depend heavily on the success of structural reforms from the Prime Minister Abe and the BoJ finance ministry.
Later this month, new measures to deregulate healthcare programs, support agricultural producers and reform labor law are likely to be announced. Public willingness to accept these changes will significantly affect consumer confidence and business spending. Both will be critical in driving near-term prospects for the domestic economy and determining the long-term validity of any rallies in Japan's benchmark indices.
At the time of publication the author had no position in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.