The plunge in Japan's Nikkei stock index dominated the week after it plunged more than 7 percent in one day, and lost more than 10 percent (from intraday high to low) across two days, before recovering late on Friday. We had long anticipated such a move because the advance in the Nikkei and the drop in the yen were nearly uninterrupted since starting in November of last year. The yen finally started slowing its descent in April, when it struggled to cross the 100 yen level against the U.S. dollar. The Nikkei never slowed down and galloped headlong into a correction that briefly shook the global financial markets. In the end though, as we wrote in Thursday's Hotline, many sell-offs have met their doom in the U.S. and by the time the bell had rung in New York, Japan's 7 percent plunge had been whittled down to a 0.29 percent loss in the S&P 500 Index.
Japan is not yet free from risk though. The proximate cause for the sell-off, besides being long overdue as investors had already begun paring their bets on Nikkei, was the Japanese government bond market. Yields have been rising as a consequence of central bank policy and this stared to worry investors that bond prices would continue falling and precipitate a crisis. Thus far there has been no sign of one, but current Japanese monetary policy will have investors on edge moving forward. The 7 percent drop in the Nikkei wiped out only two weeks of gains, to give some idea of how fast the index had been rallying, and it's still up more than 35 percent in 2013. The index should resume its upward march going forward, but volatility will increasingly come into play.
U.S. markets were weaker at the start of the week as well. Although the broader indexes moved higher, there was weakness in market leading sectors such as biotechnology and homebuilders. There was no reason for the move based on data: new home sales were higher this week and have been generally strong. Rather, as we've written recently, the market enjoyed a very rapid advance from mid-April into mid-May and it was bound to cool off. The S&P 500 Index is back where it was on May 14, seven trading days ago. Stock have now dropped out of overbought territory. If the recent past repeats, shares should see a few days of small gains or losses before the rally resumes with strength again.
Through Thursday's close, the S&P 500 Index is up 15.7 percent for the year. After January's gains we noted that the market has historically gone on to major double digit advances after such a strong start and therefore we expected a big year for stocks. May was the most likely period for a meaningful correction. Looking at the calendar, there are important Japanese elections in July, but otherwise there are few major events until the end of summer when German elections and the debt ceiling debate return. By then, the S&P 500 could see gains above 20 percent.