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Sharp Rise in Volatility Signals End to Nikkei Rally

NEW YORK ( TheStreet) -- This year's rally in the Nikkei 225 has come to an end. Recent performance in the Japanese stock index has been one of the most important market stories of the year, with regional equities posting gains of 55% from November to April.

Market optimism has been largely generated by the monetary easing programs spearheaded by newly installed Prime Minister Shinzo Abe, but a recent surge in volatility and some of the biggest single-day price declines in two years signal a major turn in sentiment. The Japanese stock index has fallen 17% from its five-year peak reached May 23 but there is little to suggest that we have yet to see the final lows for the year.

Bear markets are typically defined as any drop of 20% from a significant price high, so this latest activity in the Nikkei marks one of the most notable turns in sentiment the markets have experienced this year. Japanese stocks have not seen volatility this extreme since the Tohoku earthquake and tsunami devastated major areas of the the country's economy in 2011. This volatility has been largely attributed to weak economic data from China, upward pressure in government bond yields and possible reductions in quantitative easing stimulus from the Federal Reserve.

But the main question is whether these changes suggest growing disbelief that Japan's stimulus programs will provide sustainable growth in the long run.

While it can be argued that short-term volatility has been driven by external factors, outlook for the bigger picture rests on the aggressive central bank policy measures implemented earlier this year. In an attempt to drive growth after decades of economic stagnation, the Bank of Japan (BNJAF), has enacted programs to buy long-term government bonds (bringing down interest rates), and to double the active money supply (encouraging consumer spending). The BoJ hopes that combining low borrowing costs and larger amounts of available cash will increase spending at both the business and consumer levels, propel domestic consumption and bring inflation closer to its normalized target of 2%.

The initial market reaction to these programs was to buy Japanese stocks (in particular, export companies) and to sell the yen. Against the U.S. dollar, the yen has seen declines of almost 30% since last November.
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