'Flight of the Foreigner' in Tokyo Means Medium-Term Trading Channel

“Flight of the Bumble Bee” is a famous orchestral interlude written by Nikolai Rimsky-Korsakov and is a popular piece for those who want to showcase their instrumental technique. On the other hand, “flight of the foreigner” from Tokyo stocks over the past couple of weeks was not pretty, as the pros, not “rank amateur” individual investors, showcased their herd instinct. According to an explanation by an unnamed major hedge fund operator, “the key lesson was that too many quant managers were using the same quant factors, whose risk management was based on 'historical precedent' and gave no leeway for 'black swans'."

In other words, massive deleveraging of quantitative equity strategies by hedge funds and the dumping of positions by sell-side proprietary trading desks hit Tokyo stocks relatively harder because it was coupled with an unwinding of the yen carry trade, which whipsawed the yen by around 10% over the past month versus the US dollar and the Euro, and more like 20% against currencies such as the New Zealand dollar and Australian dollar. With foreign investors accounting for some 60% of trading in Japanese shares and owning nearly 30% of the Tokyo market, buying by domestic investors was powerless to stop the slide.

Even though ECB and Fed efforts to inject liquidity to stabilize global stock markets and unfreeze money markets has and will be helpful, the technical damage to the Tokyo market will take time to repair. In terms of the iShares Japan ETF (EWJ), the index has broken down below its 200-day moving average medium-term support line. Moreover, there is now an outcrop of cumulative trading volume between $15 and $13 that the next rally will have to digest before the EWJ index can seriously challenge its 52-week high of $15.16.

Actually, the 20% correction in 2006 marked the end of the EWJ rally that began from the 20% sell-off in 2004, and the failure to break up through this 52-week high in February 2007 was not a positive sign. While $12 is unlikely to be violated on the downside, the index could continue trading in a relatively narrow channel between $15 and $12 for the foreseeable future in much the same pattern that was seen between mid-2004 and mid-2005. Moreover, $12 support could well be tested a couple of times before EWJ is ready for the next rally.

Disclosure: Author has a long position in some of the above-mentioned securities