Will the Nikkei be a star performer in 2014?

I’m going a little off piste today. I normally cover the Dow, because it’s my favourite stock index to swing trade. But today I shall analyse the Nikkei, which appears to be on the verge of a turn. It could also be at a major turning point.

One reason for my interest is that Japanese stocks have become a highly touted sector for investors lately. 2013 was certainly a banner year for Japanese shares. The problem for overseas investors is not the booming stock market. The problem is that the yen has been similarly booming, but in the wrong direction.

Is the Japanese market finally going up?

During calendar 2013, the yen has lost a whopping 43% compared to the pound. The Nikkei, on the other hand, has gained 52% in yen terms. But in sterling terms that’s a net gain of only 13% for the Nikkei. To me, that does not add up to a booming bull market.

However, if the investor had been fully hedged, the result would have been a much more palatable 50% or so. Let’s hope the UK-based Japan unit trusts were so hedged!

During last year, comments on the Nikkei were increasingly bullish, and in some cases, very bullish. After many false dawns over the years, pundits were asking: was Japan’s market finally getting up off its knees and following the US markets upwards?

Market veterans recall the mania surrounding Japanese stocks in the 1980s. That was when the Nikkei finally hit an incredible 40,000. But since the peak in 1990, it has been downhill all the way, with occasional bear market rallies (those were the false dawns). Here is the chart:

Nikkei chart: 1970 to the present

Note the downtrend line joining the major highs that spans over 20 years. If history is any guide (and it usually is), this is a very strong line of resistance that should repel a major advance from here. That is a major piece of information.

Using history as an indicator

Let me begin my usual analysis by examining the weekly long-range chart from the 2007 highs:

Nikkei 225 spread betting chart

The Nikkei suffered a fate similar to all other global stock indexes during the crash of 2007 – 2009 by plunging over 50% from the top. But the impulsive decline was in a clear five waves, taking it in the same downward direction as the main trend (see top chart).

At the 2009 lows, note the huge positive-momentum divergence. That was a clear signal that a turn was near.

After a five wave move, Elliot wave theory (EWT) maintains that a corrective rally in the form of an A-B-C (or variation) should appear. And that is precisely what we have with the C wave currently sitting on the Fibonacci 78% retrace of the five wave down move. Now this is getting interesting!

Bull markets make investing geniuses

Now it is time to examine the form of the C wave. If I can show it is in an impulsive five-wave pattern, I can start making a strong case that the rally is about over. And after such a vigorous rally, where most pundits (and investors) are bullish and are looking for strong gains this year, I know I am sticking my neck out (not a rare event for me)!

Nikkei 225 spread betting chart

On this daily chart, I have a textbook impulsive five waves up. The third wave is very long and strong with only three red candles in all of its length in the main section! That is about as strong a third wave as I have ever seen on a daily chart.

The rally was relentless. Naturally, this performance only increased the ardour of the bulls towards their positions. Remember, markets make opinions and bull markets make investing geniuses (at least they are until the market turns).

But look at the fourth wave – it is a classic converging triangle, which acts like a coiled spring. The breakout of the triangle is like the spring’s sudden unwinding where the market zooms up out of it. But note that the momentum of this fifth wave falls well short of the maximum levels reached in the third wave. This is a textbook warning sign that the fifth wave is likely at or near the end of its journey.

Another Japanese earthquake looms

With the top chart showing the current 16,000 level hugging the major downtrend line, the warning signals are flashing that this rally could turn out to be another false dawn. But a sharp move above the trendline would change this picture.

And here is the hourly chart:

Nikkei 225 spread betting chart

I have a decent (but not superb) tramline pair and the market is currently testing my lower tramline. This is the moment of truth in the short-term. If the market breaks down here and enters chart support in the danger zone, the odds would swing heavily towards a bearish outcome.

Alternatively, the market could bounce from here and make a new high. So far, wave 5 is in only three waves which lie between the tramlines. Ideally, I would like to see five sub-waves within this fifth wave to complete before having confidence the new down trend had started. The potential remains for a new high.

But this morning, the Nikkei bull market appears to be on shaky ground and another earthquake in Japan looms.