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Nikkei's Stunning Rally—Why It’s Time to Be Cautious

Tomohiro Ohsumi | Bloomberg | Getty Images

Japan's stock market has had a blistering run,climbing 20 percent in less than two months on a weakening yen and expectations of aggressive monetary easing. Further gains now come down to the new government and whether it can come true on its pledge to revive an economy in recession, analysts said.

"I think we have got a little bit ahead of ourselves in the Japan markets, because so far all we've seen is expressions of hope and little specific going on," Mikio Kumada, executive director at LGT Capital Partners told CNBC Asia's "Squawk Box" on Thursday. "It (further gains) really depends on how much (Prime Minister Shinzo) Abe and the new government delivers on election promises."

Abe has stepped up pressure on the Bank of Japan to adopt aggressive monetary easing and a higher inflation target. The expectation of monetary easing meanwhile has pushed the yen down about 11 percent since mid-November, with the currency's weakness helping spark life into the Nikkei after several months of lackluster trade.

(Read More: Picture This: The Dollar at 100 Yen)

The Nikkei's 20 percent gain since mid-November has made it a clear outperformer among the world's major global equity markets, with the S&P 500 up about 7.5 percent and European shares rallying around 7 percent over the same period.

(Read More: Brace for Explosive Gains in Japan Stocks as Yen Slumps)

The turnaround in fortunes has prompted many to sound more upbeat on the Nikkei, with analysts polled by Reuters in December forecasting the index to rally to 11,000 this year, a gain of about 3 percent from current levels around 10,660.

Kumada said LGT Capital Partners, an investment firm, had decided not to increase its exposure to Japanese equities for the time being and wait for more signs of a sustainable turnaround.

"The problem is that Japan has a history of disappointing politically. At least Abe has a good chance because he has a strong mandate," said Kumada.

Abe was prime minister in 2006-07. His Liberal Democratic Party and its junior partner New Komeito secured a two-thirds majority in parliamentary elections last month, putting it in a strong position to push through its plans.

Japan's Nikkei 225 Stock Index

Geoff Lewis, global market strategist at JPMorgan Asset Management in Hong Kong agrees on the need for caution, saying the firm has a neutral position on Japanese shares.

"Japanese shares have rallied quite a lot, with markets anticipating a big change in policy, but a lot now rides on implementation.Short-term, this is not a rally you really want to chase," he said.

"It's pretty hard to predict what the outcome will be. The first Abe regime was pretty disappointing and did not achieve much and if you look at the amount of stimulus that the Japanese economy might hope to get from a 10-15 percent fall in the yen, it's not that much," Lewis said referring to expectations for a weak yen to boost economic growth between 0.25 percent and 0.5 percent in the fiscal year starting April 1.

Japan's economy has slipped into a recession,dented by weak demand globally and a fall in exports to China following a territorial spat that flared up last year. Latest economic data highlight the economic weakness, with factory output falling a much weaker-than-expected 1.7 percent in November from the previous month.

(Read More: Is This the Year Japan Steps Up Its Military Role in Asia?)

Think Big Picture

For some analysts, while there is a risk that Tokyo will be unable to deliver big economic reforms, there is little doubt that the long-term outlook for the Nikkei has improved following recent political developments.

The new government published a draft of an economic stimulus package earlier this week and the Bank of Japan is expected to discuss the government's proposal to lift its inflation target to 2 percent from 1 percent when it meets later this month.

"There will be a change in policy and they (Bank of Japan officials) have good reasons to follow what the new government is proposing," Norman Chan, head of investment at Calibre Asset Management said on CNBC Asia's "The Call."

Sean Darby, chief global equity strategist at Jefferies in Hong Kong, expects the Nikkei to rally to 11, 860 this year, a gain of about 10 percent from current levels.

"There has been disbelief about how fast the market has moved and in the short-term it has overshot, but last year it was so undervalued that at some point there was going to be a big rebound in sentiment," he said.

"The chances are that we are going to get better responses than we have had over the past decade. Whether that meets all the aspirations of the market remains to be seen. I would not want to be too cynical about it," he added.

By CNBC's Dhara Ranasinghe

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