It seems the long-awaited correction has arrived with a bang.
The Japanese Nikkei index fell by more than 7% on Thursday morning our time. Even given the fact that it’s nearly doubled since November last year, that’s a nasty fall.
This morning’s session was almost as volatile – the Nikkei ended a little higher, but swung between as high as 15,000 and as low as 14,000 during the session.
So what caused the carnage? And is this a rather dramatic end to a spectacular but brief bullish phase for Japan? Or just a pause for breath?
The three main factors spooking markets
Global stock markets all looked somewhat poorly yesterday, but Japan took by far the biggest overall kicking.
It’s hard to pin Thursday’s plunge on any one event, but there were several obvious triggers.
Firstly, there’s the fear of ‘the taper’. This is the term being used by financial pundits to describe the Federal Reserve’s gradual withdrawal from quantitative easing (QE).
Now, please note that the Fed isn’t actually pulling out of QE yet. And when Fed boss Ben Bernanke spoke to US politicians about it on Wednesday, he seemed fairly relaxed about the whole thing. He warned that a premature retreat would risk harming the recovery, something that he has no intention of doing.
Markets actually spiked higher on Bernanke’s chatter, believing it meant more QE as far as the eye could see. (In fact, the Nikkei’s fall was even more dramatic than it looked – in the futures market, the Nikkei nearly hit 16,000 just after Bernanke’s speech).
Trouble is, we then got the minutes from the last Fed meeting. And they were a lot punchier. Several members reckoned that QE could start winding down as early as June. The idea that the biggest central bank in the world really was thinking about starting to turn off the taps spooked liquidity-hooked investors.
Secondly, we saw a disappointing report from China. A survey from HSBC suggested that manufacturing activity is slowing down. China seems to have replaced Europe as the investment bogeyman for this year. Investors had been hoping that the new leadership would just print loads of money and keep the Chinese economy bubbling along. But it seems it’s not as easy as that.
If China wants to modernise its economy, it’s going to have to brace for some uncomfortable times. And given the huge amounts of debt China is carrying, everyone is a little jittery about the potential for a future banking crisis emerging from that direction.
Finally, there’s the small matter of Japanese government bonds. Japan is trying to encourage inflation. Inflation is bad for conventional bonds (which pay a fixed income). Therefore, you’d expect bond yields to rise (as the price falls).
But Japan owes an awful lot of money. Gently rising yields are one thing, but the last thing investors in this historically rather staid market want to see is prices bouncing about all over the place. And bond volatility has jumped since the QE measures were announced. At one point on Thursday, the ten-year yield rose above 1% for the first time this year.
Now, the Bank of Japan should be able to control the bond market. After all, it’s buying a lot of bonds via QE. And that’s just what it did yesterday – reined in the market by piling in and buying more bonds. But this sort of thing is hardly calming for investors’ nerves.
Sometimes, you’re just due a correction
All that said, perhaps the most obvious explanation for the plunge is that a correction was rather overdue. As Capital Economics acknowledges, even after the big tumble, the Nikkei had risen by more than 65% since November. When a market has risen that far, that fast, it’s going to be vulnerable to a major reaction when sentiment turns.
So what should you do now? Jonathan Allum of SMBC Nikko Capital Markets notes that in the past, daily declines of more than 6% in the Topix index (Japan’s equivalent of the S&P 500) have “generally been buying opportunities”.
It’s only happened on 12 occasions since 1980, which doesn’t give much of a sample size. (And half of those came during the global collapse of October 2008.) But on average, the market ends up higher both a week and a month after such declines.
I also suspect that having seen the general market reaction to the merest sniff of a ‘taper’, Bernanke and his colleagues might be a little more reassuring in the coming weeks.
That said, the correction could continue further. People who got in early this year and couldn’t believe their luck will be tempted to take profits off the table. And those who didn’t get in at all will be tempted to wait for a better moment to get in.
Good luck to them. Trouble is, timing the market is very tough. Most investors are terrible at it, as countless studies have shown. So, as I’ve noted on several occasions this year, I think the most sensible way to invest in these markets is to drip-feed money in to your favourite sectors.
That way, you don’t have to try to time the highs or the lows. Bear in mind that you should be investing for ten years or more – you don’t have to worry about catching the ‘best’ day of 2013 for putting all your money in the market.
And of course, don’t put all your eggs in one basket. As my colleague Phil Oakley pointed out yesterday, you shouldn’t be betting the house on a single outcome. You should have a diversified portfolio.
For more on the principles of building one, you can sign up for our free MoneyWeek Basics email. And if you are looking for a more specific portfolio map to follow, you should take a look at Phil’s Lifetime Wealth newsletter.
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