Why the Nikkei rally will carry on

Kevin Winter | Getty Images

Japanese stocks seem to be on an irresistible rally, hitting fresh fifteen-year highs for seven straight days, and cheap valuations are expected to propel them to greater heights, analysts say.

"We are bullish on Tokyo stocks – we don't see a major correction before the next consumption tax hike in April 2017," BofA-Merrill Lynch's equity strategist Kenji Abe told CNBC by phone. BofA-Merrill Lynch has a 21,700 Nikkei target for the end of March 2016.

For decades, global investors have steered clear of Japan. Not only was the country plagued by decades of deflation but its companies were notorious for hoarding cash. But a sharply weaker yen since Prime Minister Shinzo Abe's return to power at the end of 2012 has not only bumped up corporate profits but is also making their stock valuations look cheap in U.S. dollar terms.

Even global investors are piling in. In May, 42 percent were overweight on Japan stocks, the highest level this year, according to BofA-Merrill Lynch's global fund manager survey.

Most also view Japanese shares as undervalued, suggesting Tokyo stocks "are likely to continue to rise when the economic recovery and earnings improvements are confirmed," said Abe.

The benchmark Nikkei index is up 17 percent so far this year, after rising 8.5 percent in the whole of 2014.

"Japanese equities have been outperforming U.S. and European equities in U.S. dollar terms", Goldman Sachs said in a note last week. As a result, "investors who are underweight Japan have underperformed against their benchmarks."

Both BofA-Merrill Lynch and Goldman see more upside: BofA-Merrill Lynch's target for the end of March 2016 is 22,700, while Goldman's year-end target is 21,700.

Irresistible returns

The party may be just getting started.

Not only have Japanese equities been outperforming U.S. and European stocks in U.S. dollar terms, but Japanese companies' earnings growth going forward will trump those of their peers in the U.S. and Europe, according to Goldman Sachs.

Why JP Morgan is bullish on Japan stocks
Why JP Morgan is bullish on Japan stocks   

Projected earnings per share at listed Japanese corporations are set to jump 22 percent this year, compared to 8 percent in the U.S. and 5 percent in Europe, the bank said.

And investors can look forward to some generous returns. Japanese companies have not been as profitable in 30 years and, pushed by government reforms, are shaking off their reputation of being cash hoarders.

"We expect total shareholder returns to reach 13 trillion yen ($107 billion) in fiscal 2014 …and to expand a further 25 percent to reach 16.3 trillion in fiscal 2015," Goldman said.

Minor road bumps

In the short term however, Tokyo stocks could hit resistance levels, technical analysts say.

"The next resistance line is 20,800 and the Nikkei could go there as early as middle of this week," Daiwa senior technical analyst Hikaru Sato told CNBC by phone. On early Tuesday Asia trade, the Nikkei was up 0.06 percent, its eighth straight day of gains.

Daiwa, Tokyo's perma-bull, expects the Nikkei to stay range bound after hitting 20,800, but it tips a summer rally starting in July, with the Nikkei to hit a peak of around 22,500 for the year by the end of September.

"The Nikkei is a good long term bet," Daryl Guppy, CEO of Guppytraders.com, told CNBC by phone. His year-end target is around 22,500.

Guppy sees the resistance at 24,000. "The breakout has happened, now prepare for the consolidation, then a rebound to the longer term targets," he said.