Thursdays have been the Nikkei's (NIKKEIINDICES: ^NI225) bane over the past month. Japan's leading stock index has plunged every Thursday for the last few weeks, starting with a 7% fall that began the index's month-long streak of volatility and continuing today, when the Nikkei lost another 6.4%. The index has still outperformed many of the world's indexes year to date, but today's plunge offers more proof that investors are jittery over Japan's rapid rise on the back of Prime Minister Shinzo Abe's aggressive stimulus plan.
Should they be worried about a real drop, or is this another case of short-term traders selling into a self-fulfilled prophecy? Let's take a look at why investors are panicking about Japan's future and what it means for your investing strategy.
An up-and-down yen spurs an up-and-down market
Abe brought about stimulus in response to one of Japan's worst economic problems of the last half-century: more than two decades of a stagnant economy and deflation. Weakening the yen against other leading currencies would be a boon for leading Japanese exporters looking for an edge against overseas competition. Manufacturers such as Komatsu (KMTUY -2.45%) have applauded the moves as they look to use a weak yen to grow profits. Komatsu alone projected 46% full-year profit growth this year thanks to the weak yen.
However, the yen's not the only currency that can fluctuate. The dollar's recent weakness has strengthened the yen against the U.S. currency, and if Japan's currency can't make up ground, exporters' results could miss those lofty expectations. The fluctuation of the yen is something investors and firms can't control, and while it's a justified concern, easing won't end in Japan anytime soon. As stimulus picks up, it's more likely that the yen will weaken further as investors settle down somewhere between the Nikkei's rapid early-2013 growth and the recent sell-off.
Automaker Toyota (TM -1.08%) is a perfect example of how the yen's volatility can affect a company's - and thus a stock's -- performance. The company reported superb results in its most recent quarter as the weak currency helped Toyota more than double its year-over-year net profit and project more than 42% earnings growth for the full year. Toyota's stock has surged more than 29% year to date on those high marks, but if the yen strengthens instead of weakening in the months ahead, Toyota will be hard-pressed to match those lofty projections -- and disappointment is sure to negatively impact a stock.
If Abe's plan doesn't come to fruition and Japan's nascent recovery fails, however, more than just export stocks could be in trouble. That's a major fear many investors share -- that stimulus won't be enough to kick-start Japan's struggling economy. Easing should spur more lending and greater investment in the Japanese economy, but rising bond yields and growing interest rates could threaten the Japanese economy's progress.
The nation's massive debt is a big part of this fear. Japan leads the world in public debt with a 245% debt-to-GDP ratio. Rising interest rates would greatly hamper the government's financial flexibility, and with Japan's population aging and leaving fewer workers to support a growing elderly segment, the country could be hard-pressed to service that debt over the long term.
Finally, many investors are worried about the impact of other economies on Japan's stocks. China in particular has sparked investor fears after the country's growth has slowed recently. With China still facing a number of economic problems at home, the days of double-digit economic growth in the world's largest country could be gone. While China's still one of the world's fastest-growing economies, slower-than-projected growth will weigh on firms that rely on business there.
The aforementioned Komatsu is the leading manufacturer in China, ahead of American rival and global manufacturing leader Caterpillar. While Komatsu has aimed to chip away at Caterpillar's lead using China's growth, sluggish Chinese infrastructure investment will thwart this company's ambitions and keep its stock from reaching its potential.
Nevertheless, the Nikkei's nearly 16% fall in the past month has been a drastic correction to the index's earlier gains. Japanese stocks probably did rise too fast in the initial enthusiasm behind Abe's aggressive economic plan, but they've similarly dropped far too quickly as overhyped fear has fueled a rash of itchy trigger fingers on the market. The Nikkei's real potential lies somewhere between that meteoric rise and the recent plunge; Japan's climb from stagnation to a healthy economy will take time. Investors will undoubtedly subject the Nikkei to more volatility between now and then, but those with a long-term view will recognize Japan's plan for what it is: a rebuilding process to strengthen the world's third-largest economy for the long run. Keep an eye on the Japanese economy, but day-to-day currency fluctuations are no reason to sell.
