Investors Panic as Japan Gets a Wake-Up Call

Crash! That's the sound of Japan's Nikkei (NIKKEIINDICES: ^NI225  ) stock index today as investors watched it plunge by 7.3% overnight. It was the index's worst single-day drop since Japan's 2011 tsunami and a massive shock after Japanese stocks kicked off the year with the hottest start in the world. Welcome back to reality, Japan.

It's hardly the end of Japan's recent surge, but today's drop is a reminder of just how fragile the country's recovery from more than two decades of stagnation is. Are the Nikkei's best days in 2013 behind it, or is today's heartache just a blip before more gains?

Investors flee from the fallout
As far as drops go, today's wasn't sparked by anything nearly so catastrophic as the tsunami two years ago. A rise in Japan's bond yield to more than 1% didn't help the markets any, as Prime Minister Shinzo Abe's massive stimulus plan has aimed to keep rates low and encourage borrowing. Federal Reserve Chairman Ben Bernanke's announcement yesterday that the Fed could consider winding down quantitative easing in its next few meetings also heightened investor fears overseas.

A bigger shock came from China. HSBC's flash purchasing managers index for China fell into contraction territory for the first time since last October, indicating that the world's second-leading economy may be slowing down more than once thought. China's government predicts annual economic growth of just 7.5% this year, below the growth of recent years. Today's move may spur the government to take steps to counter any further slowing.

This is especially bad news for some of Japan's top exporters. Japanese companies have been counting on a weak yen, devalued by the Bank of Japan's aggressive monetary easing, to improve competitiveness against overseas companies. Many firms have targeted China in particular in order to take advantage of Japan's fast-growing neighbor and get a leg up on American rivals looking to capture market share.

Japanese auto stocks could be hit hard by a more significant Chinese slowdown. Toyota (NYSE: TM  ) already trails top rival and Chinese market leader General Motors (NYSE: GM  ) , and slower growth in China could derail Toyota's hopes of capitalizing on the country's auto market. GM's China sales in January and February grew 8% this year to increased its lead over Toyota, which has seen sales falling in Asia's top economy. If China's growth wanes, Toyota and its fellow Japanese automakers may be forced to invest more heavily in other nations to find the kind of growth they want. China is still expected to be the top automaker in the world by the next decade, according to GM, but earlier growth projections could be overly optimistic.

A decline in Chinese manufacturing means even more to investors in Japan's industrial firms, such as Komatsu (NASDAQOTH: KMTUY  ) . Komatsu's stock fell more than 6% today amid the Nikkei's drop, and while it is the industrial market leader in China, falling manufacturing won't help the company capitalize on its position -- weak yen or not. Komatsu has counted on a weak currency to boost its competitiveness against top rivals such as Caterpillar, but if China's manufacturing sector can't continue growing, Komatsu will have to expand geographically to compensate. The firm still has a lofty outlook for the year, but it may have trouble fulfilling investor's expectations.

The biggest driver of today's major drop, however, was fear. The Nikkei's rapid rise has owed heavily to investors buying into "Abe-nomics" and the country's unprecedented stimulus plan. After such a meteoric rise to kick off 2013, a sell-off was bound to occur -- and it only took the slightest bit of bad news to plant a seed of doubt and spark investor panic. The news from China is a big hit to investors, but selling based on the fearful emotions of other investors isn't a smart move.

The Nikkei's drop isn't the end of the world, and Japan's stimulus measures should continue for quite a while. Abe intends to hit 2% inflation with his easing, and his economy is still far from that goal. While I expect the Nikkei to continue rising throughout the year, this index's foundation of easy money and lofty expectations will bring more volatility in the months -- and maybe years -- ahead. For investors who can weather the storm of ups and downs to come, Japan can still reward a portfolio in a big way.

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