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Written by Xia Chun, Chief Economist and Director of the Research Institute of Shangshan Capital Group

On Monday, the Nikkei index fell 12.4%, losing 14 months of gains in one day. This is the largest single-day drop in the Nikkei's history. It should be noted that since the establishment of the Nasdaq index, the largest one-day drop was only 12.3%, which occurred during the impact of the epidemic in 2020. The S&P has only experienced a larger drop once, which occurred on October 19, 1987. Global investors encountered another "Black Monday".

The sharp drop in Japanese stocks is closely related to the reversal of yen carry trade and the appreciation of the yen. However, the yen rebounded by 16% at the end of 2022 and 7% at the end of 2023. Although the Nikkei index also fell back at that time, the decline was very limited. The yen has only appreciated by 13% recently. Why has the Japanese stock market fallen so sharply?

It turns out that the main institution engaged in carry trading is Japan Overseas Insurance Company. Although carry trading is simple and effective to make money, it does involve exchange rate risk. Therefore, insurance companies will take measures to hedge exchange rate risk, mainly through forward contracts, currency swaps and puts.Optionstrade.

The earnings reports of Japan's nine largest life insurance companies as of March 31 this year showed that up to 47% of their overseas securities were covered by hedge derivatives, but this figure was actually the lowest level since September 2011, and the highest point in March 2020 was as high as 63%. As the yen continued to depreciate against the dollar before July, these insurance companies are likely to have further reduced their hedging ratios, betting that the yen will continue to depreciate against the dollar.

However, the reality went against expectations. Starting from July, the uncertainty in the US election and capital markets increased significantly. Institutions that lent yen asked investors to reduce their yen positions. The strengthening of the yen against the US dollar caught these insurance companies, which lacked sufficient exchange rate risk hedging and suffered losses, off guard.

Now, these overseas insurance companies need to buy yen to repay them, and the yen may appreciate to around 130. Therefore, the yen appreciation may reach 20-25%, which is significantly higher than the end of 2022 and the end of 2023. This will greatly affect Japanese listed companies that are highly dependent on overseas income. Since shorting the yen and going long on Japanese stocks are the most crowded trades, this led to a plunge in the Japanese stock market on Monday.

The Nikkei has fallen 25% from its highest point this year in just 17 trading days. Historically, the Nikkei has fallen by more than 20% only four times in such a short period of time, in 1990, 2008, 2013, and 2020. However, the maximum decline in these four times within three weeks was only 23%, which shows how fierce the recent decline is.

From a trading perspective, instead of buying Japanese stocks now in the hope of a short-term rebound, it is better to continue to watch the trend of the yen. The market now believes that the Federal Reserve may suddenly announce an early interest rate cut. I have explained before that this kind of rescue-type interest rate cut is very helpful to the stock market.

Of course, this timeBlack SwanThe incident also tells us that it is far more important to make good strategic and tactical allocation of assets than to focus on one track. If you want to cross the bull and bear markets, you need to make multi-track and multi-variety allocations. Only by withstanding the decline can you rise better.