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Chart Pattern Predicts a Big Run for Japan Into Year-End

Japanese stocks woke up this week after a four-month slumber. No doubt, the sinking Japanese yen has a lot to do with stock market strength, but pure chart watchers have plenty of evidence to make them happy as well.

 

The benchmark Nikkei 225 index rallied nicely in late 2012 into early 2013 as the yen moved lower. But in mid-May, the yen suddenly reversed course. On May 22, the Nikkei tumbled 7.3% to not only end the preceding rally, but kick off a 20% correction.

After regaining about two-thirds of that loss, the market settled into a pennant formation starting in July and lasting into this month. Each successive rally and decline covered less ground as volatility diminished and emotions settled.

Interestingly, the entire pennant centered on the still rising 50-day moving average. Considering how sharply the index fell earlier in the year, this suggested that the market was seriously overheated but still in a bullish trend. With Thursday's 2% rally, the Nikkei moved out from the pennant and the bull market can now continue.

Of course, most domestic investors cannot buy the Nikkei itself. Many are familiar with the iShares MSCI Japan ETF (NYSE: EWJ), but there is a currency bias built in. For an ETF that more closely mirrors the Nikkei itself, take a look at WisdomTree Japan Hedged Equity (NYSE: DXJ).

DXJ Chart

The chart shows the steep run-up into the sharp May 2012 correction. It also shows the ETF moving sideways in its pennant formation until meeting the rising and supporting 200-day moving average.

The pennant borders are drawn to ignore the Aug. 30 low, but in doing so, they represent the action better. Since this is an ETF that trades when the home market for the index it tracks is closed, we can accept an occasional violation of support or resistance as long as the rest of the data points make sense. They do here.

Using the size of the pennant, we can determine an upside objective for the breakout. If we measure its vertical height and project that up from the breakout point, we get a target of roughly $55 -- about 1 point above the May high. This could happen by year's end if the market moves in a similar manner to previous rallies, excluding the steep final run into the May high.

Recommended Trade Setup:

-- Buy DXJ at the market price
-- Set stop-loss at $47.50
-- Set initial price target at $55 for a potential 12% gain in eight weeks