Japan Research- Investment Advice in troubled times

The recent Japanese earthquake is of epic proportions and has led to unchartered territory in terms of Japan’s preparedness for a nuclear catastrophe. The Japanese archipelago is located in an area where several continental and oceanic plates meet. This is the cause of frequent earthquakes in the island nation. The worst natural calamity to strike Japan prior to the most recent tragedy was the 17th Jan 1995 Kobe earthquake.

Let us look at the Nikkei-225 prior to the 1995 earthquake. The chart below shows us the price graph from October 1994 till Jan 20 1995 with the highlighted portion detailing the market collapse after the earthquake.

To compare the US markets, we have looked at the S&P 500’s correlation with the Nikkei-225.

This chart shows the 60-day rolling correlation of the S&P 500 from March of 1994 till the 17th of Jan 1995. The trend line in the chart indicates very little correlation between the Nikkei-225 and the S&P 500. But what is interesting to see is the change in the correlation chart post the Kobe earthquake, as shown in the attachment below.

The trend line indicates the clear shift in the trend between the two indexes.
What will be interesting to see is how, the Nikkei-225 fared after the Kobe tragedy.

As is evident from the chart the Nikkei bounced back and followed the S&P 500, which was in the middle of an extended bull run, continuing its upward surge throughout 1995.

Cut to the recent tragedy in Japan, let us take a look at the correlation of the two indices in question, S&P 500 and Nikkei-225 in recent times.

This above chart shows the 60-day rolling correlation of the S&P 500 from April of 2009 till the 15th of March 2011. The trend line in the chart indicates significantly higher correlation between the Nikkei-225 and the S&P 500 than that witnessed in 1995. In fact if we take a closer look at the trading week of the tragedies in 1995 and 2011, we will notice that the average 60-day correlation for the 5 trading days after the 1995 disaster was 7.7% while the last week has seen an average 60-day correlation of 25.5% between the Nikkei and the S&P 500.
Of course part of this could also be attributed to the impact that the North African crisis but there is no denying the significant coupling of the Japanese and US equity markets. If we take a closer look at the volatility in the Nikkei-225 before and after the 1995 tragedy we will notice that the 6-month standard deviation before the 1995 crisis was 0.69% whereas 6 months after the crisis this volatility doubled to 1.4%. This would suggest that with the increased correlation between the two markets and also accounting for the greater damage caused by the recent tragedy, the US markets would share some burden of the volatility going forward.
In addition to the equity markets, the currency rates have also been impacted by the tragedy. If we take a closer look at the USD/JPY exchange rates in 1995 we see a short-term strengthening of the dollar due to the yen inflow in the country post the tragedy.

If we look at the YTD exchange rate chart in 2011, we will notice a similar trend reversal which we think will be similar to what was witnessed in 1995.

From an investment opportunity stand-point, I feel this should be a good time to re-evaluate new positions in VXX and FXY for the short-term.