Japanese Nikkei Faces 20% Correction Unless Bank of Japan Increases Stimulus

NEW YORK (TheStreet) -- Japanese equities, measured by the Nikkei 225 index, are off to another impressive year so far, outperforming the S&P 500 by almost 10 points. The Nikkei 225 even reached a historical milestone this year, reaching levels not seen since 2000. While bulls celebrate these fresh 15-year highs, storm clouds are gathering overhead, as the market creeps closer to a significant correction.

In March, I expressed my concern about a looming top in Japanese equities, but proposed that there was still near-term upside left, citing a target of 20,000. Last month, price slightly exceeded that target by roughly 250 points, and has since dropped over 4%. Before we can confirm that price has struck a significant top, and begun the 20% correction suggested in that article, the March lows made at 18,928 and 18,577 respectively must be breached. Until then, there is an opportunity for the Bank of Japan to extend this rally through the summer for a blow-off top.

Since pledging in 2013 to achieve 2% inflation and pumping trillions of yen into the markets, the Bank of Japan is still struggling to meet that target. However, the core consumer price index in Japan rose in March for the first time in almost a year, along with other data that offered signs of encouragement. This creates an interesting environment for members of the policy board, and their upcoming meeting on May 21 and 22.

On the one hand, the Bank of Japan has made it clear that it will do whatever it takes to meet the inflation target, including adding even more stimulus to markets through the current asset purchasing program. On the other hand, with increasing dissent and decreasing popularity for the experimental program, members may not be eager to add more stimulus, especially since data is starting to show that their efforts may finally be having an effect.

It is unlikely for the Bank of Japan to reduce stimulus during its upcoming policy meeting, but keeping policy steady may not be enough to keep the Nikkei 225 elevated at its current level. From a technical perspective, this rally is getting stretched, going on roughly 18 weeks now without touching the 200-day moving average. Accompanied by negative divergences on technical indicators, a reversion to the mean appears likely. While it would just delay the inevitable, the only way this rally continues is if the Bank of Japan decides to introduce additional easing later this month.

If policy members fail to take an even more aggressive stance here, the Nikkei 225 is set up for a large correction of at least 20%. Using Elliott Wave theory along with other technical analyses, the proposed correction would take price back to 16,000-to-13,000 over the next several months, likely not finding a bottom until sometime next year. Click here for a chart illustrating this path, along with the bullish alternative if the BOJ decides to intervene. If price manages to hold the March lows and make a strong recovery, we can see one last gasp to reach roughly 21,700 before the 20% correction begins.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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