RISING YEN PUNISHES JAPANESE STOCKS -- WISDOM TREE JAPAN ETF, HOWEVER, IS NEAR MAJOR SUPPORT ZONE -- EMERGING MARKET ISHARES CONTINUE TO WEAKEN -- FOREIGN STOCK INDEX BACKS OFF FROM CHART RESISTANCE -- DOLLAR WEAKENS AS EURO RALLIES

JAPANESE STOCKS PLUNGE AS YEN BOUNCES ... Between last November and mid-May, a plunging yen pushed Japanese stocks 80% higher. Over the last three weeks, however, the short yen/ long Nikkei trade has reversed. Chart 1 shows the upturn in the Japanese yen in mid-May coinciding exactly with a peak in the Wisdom Tree Japan Hedged Equity ETF (DXJ). [The DXJ has been the most popular way to invest in Japan this year because it hedges out the negative effect of the falling yen]. A 6% plunge in Japanese stocks today unnerved other global markets and caused early selling. The good news is that the DXJ is now in a potential support area.

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Chart 1

JAPANESE STOCKS REACH POTENTIAL SUPPORT ZONE... My June 4 message showed the Wisdom Tree Japan Hedged Equity Fund (DXJ) nearing a potential support zone which is recreated in the next chart. In that earlier message, I suggested that major support should materialize around the 42 level in the DXJ. The horizontal line drawn over the 2010 peak sits near 41 and should provide support during the current correction. The shaded box area also shows the 42 level to be a 50% retracement of the last year's Japanese stock rally. Only time will tell if that support holds. I think there's a good chance that it will. That might help steady global markets.

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Chart 2

EMERGING MARKET ISHARES PLUNGE ... The biggest threat to the global stock rally is coming from emerging markets. The weekly bars in Chart 3 show Emerging Market iShares (EEM) falling to the lowest level in nine months. It has also broken a support line extending back to the fourth quarter of 2011. Emerging market bonds and currencies have also fallen sharply. My June 1 message explained that rising U.S. Treasury yields undercut demand for emerging markets by reducing the appeal of higher-yielding foreign assets. I also expressed concern that weakness in global markets might cause some profit-taking in the U.S. So far, U.S. stocks have shown amazing resilience in the face of foreign selling. That may change, however, if foreign markets don't stabilize soon.

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Chart 3

VANGUARD EX-USA ETF PULLS BACK FROM RESISTANCE ... That same June 1 message showed the Vanguard FTSE All-World ex-USE ETF (VEU) starting to back off from overhead chart resistance formed during the second quarter of 2011 (see circles). It also warned that any serious pullback from there could cause some profit-taking in the U.S. [The VEU includes the world's major developed markets, with a 25% weighting in emerging markets]. So far, the pullback in the VEU has been relatively minor. The daily bars in Chart 5 show the VEU in the process of testing initial chart support along its February and April lows. It also remains above its 200-day moving average. Since its May peak, the VEU has lost 5%. [Emerging markets have lost 10% during the same period, with Japan losing 20%]. By contrast, the S&P 500 has dipped only 3%. The ability of the U.S. market to withstand weakness in foreign markets may depend on the ability of the VEU to stay above its 2013 lows.

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Chart 4

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Chart 5

DOLLAR FALLS AS EURO RISES... Over the past week, the dollar has taken a hit while the Euro and yen have rallied. Chart 6 shows the PowerShares U.S. Dollar Bullish ETF (UUP) falling to the lowest level in four months. At the same time, the Euro has exeeded its May peak to reach the highest level since February (see Chart 7). I suspect that these are short-term reversals rather than important trend changes. Last week's announcement by the ECB that it was standing pat on monetary stimulus, and this week's Japanese announcement of the same, produced bounces in both currencies. So far, dollar selling hasn't produced much of a commodity bounce.

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Chart 6

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Chart 7

WATCHING THE VIX CLOSELY ... I'm keeping a close eye on the CBOE Volatility (VIX) Index for any sign of an upturn. That's mainly because a rising VIX is usually associated with a stock market correction. Chart 8 compares the VIX (black line) to the S&P 500 (green line) over the last four years. The VIX has stayed relatively subdued during those four years, which has helped support a rising U.S. stock market. Two upward spikes in the VIX during 2010 and 2011 (red circles) produced S&P corrections of 14% and 19%. The VIX has remained unusually low over the last two years which has kept stock pullbacks relatively mild. Minor upturns during 2012 produced S&P pullbacks of 9% and 8%. So far this year, market pullbacks have averaged 3%. Needless to say, any upturn in the VIX could cause a bigger market pullback. There's another reason to keep a close eye on the VIX. Correlations between markets usually weaken during periods of low volatility. That's especially true of global stock markets. Chart 9 shows a widening divergence between a rising S&P 500 and falling Emerging Market iShares (red line). More importantly, the six-month correlation coefficient (below chart) has fallen to the lowest level in five years. That degree of negative correlation between global stocks markets is highly unusual. Rising volatility usually tightens correlations between global markets, especially on the downside. That's another reason to keep a close eye on the VIX Index.

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Chart 8

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Chart 9

S&P 500 TESTS 50-DAY AVERAGE AGAIN ... Chart 10 shows the S&P 500 retesting its 50-day moving average (blue line) for the second time in a week and a support line drawn under its 2012 and 2013 reaction lows (green line). It has to stay above both lines to keep its uptrend intact. A close below both lines would be a negative turn for the U.S. market. The bars below the chart show the VIX Index bumping up against the top of its 2013 trading range (19.28 on an intra-day basis). It's down today (down arrow), but any close above the black resistance line would be cause for concern.

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Chart 10

CLOSING UPDATE: MARKET ENDS STRONG ... Although this message was posted earlier this afternoon, I've updated the charts to reflect today's strong stock market close. The S&P 500 gained nearly 1.5% on the day. All market sectors scored impressive gains. Foreign stock ETFs experienced upside reversals as well, with a 2% upside reversal in Emerging Market iShares. Japanese ETFs also closed higher. The VIX ended down 11% today which supported the stock rally. The day's action represented an impressive upside turnaround in stocks, especially given the weak start in foreign markets. The only weak spot was volume, which appears to be on the light side. Some commodities (like copper and energy) ended higher and may have gotten some help from a weak dollar.