Up by the stairs, down by the elevator. Yesterday’s equity sell-off in Japan highlights the somewhat shaky foundations that this year’s equity rally has been built upon. Optimism is contagious, but pessimism is arguably more infectious.

Shortly after hitting a resistance zone around 16,000 the Nikkei 225 lost the most ground in one day since the tragic earthquake of 2011, plummeting over 7.0% in yesterday’s session. But there wasn’t one overriding cause of the sell-off. Instead, a toxic cocktail of negative sentiment, yen strength and multi-year highs poisoned the Nikkei. Yet, is the sell-off the surprise or the fact that it took so long?

While China’s May private sector manufacturing PMI was disappointing, it was by no means disastrous. And, the market’s reaction to Bernanke’s comments about possibly ending QE3 sooner than previously anticipated if economic data provides the base for an early exit were overdone in our opinion. It’s not new news that the Fed monitors US economic data in order to determine the severity/duration of quantitative easing. In fact, the bank made this clear when it announced QE3. Likewise, we didn’t consider the push higher in the yen to be extreme. USDJPY remains comfortably above 100.00 and has since regained most of its lost ground.
Hence, it appears that the Nikkei’s record run higher may have been built on rocky foundations. Therefore, a further correction to the downside cannot be ruled out in the short-term, especially if global sentiment starts to turn.

However, potential dips in the near-term may be opportunities to get long. As we have previously stated, Abeonomics appears to be working. While we aren’t overly optimistic about the monetary policy side of the equation – we don’t think the BoJ can reach its 2% inflation target (current market inflation expectations, as judged by futures pricing, aren’t very optimistic either) – we are however optimistic about Abe’s economic policy as a whole. Our biggest concern is Japan’s aging population, but there are ways around this (immigration, incentives, etc.).

From a technical standpoint, the recent price correction to the downside isn’t entirely surprising. Since mid-November the Nikkei 225 has posted gains of around 85%, so a 7.5% drop isn’t enough to suggest the index’s upward trend is over, especially given the record amounts of volume that lifted the market to its recent highs.