Japan's Growth Story Hits a Crossroads

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Japan's crushed investor expectations in 2013, and the Nikkei's (NIKKEIINDICES: ^NI225  ) had a banner year. The country's leading stock index has surged more than 38% year to date, and added another 2.6% to its yearly haul over the past week.

Signs are looking up in the world's third-largest economy, as prime minister Shinzo Abe and the Bank of Japan try to get the economy on pace and out of its multi-decade slump of years past. But it won't be so easy for Japan to just turn on the economic gas: Obstacles stand in the country's way, from Tokyo's plans and the country's debt, to global movements out of Japan's control. Should investors have confidence that this surging market can keep up its momentum?

Challenges ahead
The Bank of Japan's feeling confident. Abe's long touted his 2% inflation target for an economy that's struggled with deflation for years, and the BoJ said this week that the country's on pace to hit that mark down the road.

Even with that endorsement, however, deflation fears are still high. Much of that is due to Tokyo's proposed sales tax hike this year in order to counter the country's runaway public debt. While making some sort of revenue-generating move looks necessary for Japan's government to rein in its debt, increasing taxes on consumers could hit spending just when Tokyo's hopeful that consumers will pick up the pace. It's a classic case of biting the bullet in the short term to mitigate long-term risks, normally a sound strategy -- but in Japan's case, Tokyo has to make sure that the short-term impact of the tax, if it passes, won't cripple the economy's turnaround.

Worse for Japan, however, are fortunes entirely out of its hands. The slowdown in emerging markets, and other top economies, has worried economists and investors. One BoJ board member called lackluster global growth, particularly in large markets such as the U.S., a critical threat toward the company's exports.

Leading exporters have taken advantage of the yen's fall this year, and a drying-up export market would be a big blow to companies counting on the weak currency to shore up their bottom lines. Unfortunately for investors, the Nikkei's bounced around wildly on the yen's swing, and more volatility's likely to come. It's a trend investors can't plan for. The best case is to pick out Japan's best stocks and companies and to wait out the market's fickle moves, as Japan works its way back to sustainable growth.

Unfortunately, the yen's impact on stocks has blurred the lines on investments. Look no further than down-on-its-luck camera maker Nikon (NASDAQOTH: NINOY  ) . Nikon's shares gained more than 8% over the past week due to the yen's weakness, as the company rakes in more than a quarter of its sales in Europe. Still, the stock's lost more than 43% year to date.

Nikon's anything but a comeback story. This company's in a declining business, as rising tech firms knock out older camera makers, and Nikon already saw its first-quarter profits fall 72% year over year. Don't let Nikon's rise this week affect your investing thesis; like some of Japan's weaker firms, it's hitting a temporary bump because of the yen's volatility on what's otherwise been a downward spiral all year.

Nikon's story is similar to what's plaguing its Japanese rival, Canon (NYSE: CAJ  ) . Canon's stock has nosedived by 20% year to date, but the stock's recovered nearly 3% over the past month. Don't let appearances fool you: The company slashed its full-year sales and profit forecasts back in July, as the worldwide camera market has slumped, and as smartphones continue to take over this aging niche. Canon's route back to respectability looks like a treacherous climb.

The weak yen is a boon for truly great companies in Japan that hold strong positions in their industries, such as Toyota. But for Canon, Nikon, and other firms struggling with waning outlooks, the currency's fluctuations will only hold off their falls in the short term. As always, it's critically important that you do your homework on a company before investing in Japan's surging stocks, and think for the long term, not for what the yen's fall in 2013 can get you.

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