In this round of the Japanese stock bull market, 90% of foreign capital has already exited

In the past three trading days, the Japanese stock market has experienced three consecutive declines, especially staging a "Black Monday" this week, causing a collapse in the Asia-Pacific stock markets. The Nikkei 225 index fell by over 12% on Monday, and the Nikkei 225 Volatility Index also soared to the second-highest level in history at 70.69, with global risk capital flowing back to U.S. Treasuries.

JP Morgan warned that there may still be "black swans" in the market that are unknown at the moment. Otherwise, without the impact of incidental events such as war, epidemics, natural disasters, or financial crises, it is unlikely to see such a large-scale sell-off in the Japanese stock market in the past few days. In the next month, it is necessary to closely monitor the occurrence of historical political and economic turmoil that could put Japan in a certain "epicenter".

Overseas investors have been selling Japanese stocks since last week

In a report released on the 5th, JP Morgan pointed out that last week (July 29 to August 2), the selling pressure on MSCI Japan Index stocks expanded to 1.1 trillion yen. It is estimated that overseas investors have been selling heavily in the Japanese stock spot market, having sold about 90% of the net purchases made since the "Japanese stock boom" started in April 2023. The Japanese stock spot market is approaching a peak in selling. However, the position adjustments of CTAs in the futures market are significantly lagging behind. If CTAs completely liquidate their positions, the Nikkei 225 index may further decline to 27,000 points.

We believe that the Japanese stock spot market may be entering a peak in selling. At the same time as the appreciation of the yen, the momentum effect of Japanese stocks is rapidly weakening, with overseas investors and Japanese retail investors aggressively selling in the Japanese stock spot market.

The chain reaction of selling in the Japanese stock market is driven by trend-following investors (retail investors, hedge funds, etc.) accelerating their selling in the Japanese stock spot market, in addition to widespread selling of leading Japanese stocks by overseas investors.

Is this round of Japanese stock market plunge just the beginning of a bear market?

JP Morgan also believes that the Japanese stock market may be approaching the early stages of a bear market: data shows a chain reaction between the rising correlation among stocks and the soaring volatility, which may trigger a situation of "selling everything".

During the period of selling by overseas investors, the volatility of the Japanese stock market surged, with the Nikkei 225 Volatility Index (VI) reaching 70.69, which is an extremely high level, surpassing the periods of Japanese stock volatility in 2011, 2018, and 2020, second only to the historical record of 92.08 on October 31, 2008.

Is the recent sharp drop in Japanese stocks a "black swan" event?

Morgan Stanley believes that the recent sharp drop in Japanese stocks is more like a "black swan":

Generally speaking, without events such as war, epidemic, natural disasters, or financial crises, Japanese stocks would not experience such significant market turmoil over the past three trading days.

However, we cannot rule out the possibility of a black swan event occurring in the market, as such events cannot be observed from the surface of existing data and information.

We hope to closely monitor the possibility of Japan becoming the epicenter of some historical political and economic turbulence within the next month.

Several factors contributing to the short-term plunge in Japanese stocks include:

Rapid deterioration in the supply-demand relationship of Japanese stocks, with a large number of long positions established based on momentum investment strategies being sold off, including CTA selling Japanese stock futures, selling Japanese stock spot, and yen arbitrage trading, etc.;

Global risk capital flowing back to U.S. Treasuries (investors tend to move funds to safer assets like U.S. Treasuries in uncertain market environments).

The effectiveness of the Bank of Japan's market intervention through ETF purchases is diminishing.

What might be the future direction of Japanese stocks?

Regarding the future trend of Japanese stocks, JP Morgan believes that if the Nikkei 225 Index remains below 35,000, it will trigger further selling by CTA.

Since last week, CTA has largely driven the selling of Japanese stocks, with CTA currently having closed about 40%. If the Nikkei 225 Index falls below 35,000 points and the TOPIX Index falls below 2,400 points, then CTA will accelerate its stop-loss.

If CTA completely clears its positions, we believe that the Nikkei 225 Index may further decline to around 27,000 points.

It is important to see whether buying interest in the Japanese stock spot market will increase next. If the Nikkei 225 Index fails to return to 35,000 points in August, we believe that the Japanese stock market may transition to a bearish trend phase, with CTA liquidating its long futures positions and seeking short opportunities