As much as South Korea’s economy serves as a model for other emerging markets, its stock market looks to be in trouble. This is especially so when you compare it to Japan’s stock market.

Sure, it’s the yen that gets all the mainstream media coverage. But Japan’s Nikkei index is clearly benefitting from Shinzo Abe’s bold steps to drive down the yen’s value. We’ve talked about this before but to quickly recap, as Japan’s currency gets weaker the country’s major exporters enjoy upticks in sales to overseas buyers looking to take advantage of relatively cheaper wares.

That’s great for Japan’s companies (and their stock prices). It’s not so good for the Japanese people, who experience rising prices at home. It’s also not so great for Japan’s neighbors (and competitors), including South Korea, which also depend on exports. South Korea sells fewer Hyundais and Kias when Japan floods the global market with “discounted” Hondas and Toyotas.

Until recently, the stock markets of Japan and South Korea have moved in tandem. That all changed at the beginning of this year. As the yen weakened, Japanese stocks shot higher. Meanwhile, in the absence of market-juicing currency devaluation, South Korea’s stock market has shown weakness.

Here’s a chart of the two, with a South Korea ETF (EWY) in green and a Japan ETF (EWJ) in blue. A ratio of the two (South Korea / Japan) is plotted at the bottom of the chart.

See larger image

The question to ask, any time a divergence like this begins to emerge, is: do I expect the relationship to revert back to the historical average? Or, will the divergence become even more pronounced.

In this case, I very much expect the divergence to widen. It’s clear WHY Japan’s stock market disconnected from South Korea’s and that factor isn’t likely to change any time soon.

This situation provides a trading opportunity in the form of a spread trade…

The idea is to capitalize on Japan’s relative strength. We do this by buying shares of Japan’s ETF (NYSE: EWJ) and short selling an equal dollar amount of South Korea’s (NYSE: EWY).

If both markets continue higher, Japan’s ETF should outperform. Likewise, if both markets drop… expect South Korea’s ETF to tumble harder and faster, as it did in 2008. If either one of these scenarios play out, a long EWJ / short EWY spread trade should perform well.

Of course, the other way to play this is to hit the Toyota dealership for a killer deal on a Camry.

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Adam O'Dell
Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.