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Sentiment Turning for Japan Stocks? Foreign Investors Bail

Shibuya district, Tokyo
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Shibuya district, Tokyo

Chatter over whether Japan's soaring stock markets are due for a correction gained momentum after data on Thursday revealed that foreign investors, who have been huge buyers of Japanese equities in recent months, became net sellers in the past week.

According to data from the Ministry of Finance, foreign investors were net sellers of Japanese equities in the week through to April 20, with a net outflow of 27.9 billion yen ($281 million) after they bought 1.57 trillion yen of stocks in the previous week.

"On the short term the market looks overbought on most technicals and a snapback is increasingly likely. This may be around 5 percent, possibly as high as 15 percent over the next few weeks. It may be caused by momentum waning or a shift in policy," Rob Aspin, Head of Equity Investment Strategy at Standard Chartered Bank told CNBC. However, he added that this would provide an attractive entry point for investors.

Aspin said foreign investors are locking in profits, after being net buyers over the past 4-5 months. Foreign investor inflows into the country's stock market have totaled $63 billion since the start of 2013, 2.5 times more than inflows into the rest of Asia, according to data from J.P. Morgan.

The benchmark Nikkei 225, which has rallied 35 percent so far this year on Prime Minister Shinzo Abe's radical reflationary policies, traded near 5-year highs on Thursday. Japanese stocks are now the most expensive in Asia, trading at a price-to-earnings ratio of 23, compared to just 10.7 and 9.9, respectively, for Hong Kong's Hang Seng and South Korea's KOSPI, according to Reuters data.

Geoff Lewis, Global Market Strategist, J.P. Morgan Asset Management, who is upbeat on the market in the longer run, agrees that Japanese stocks could be vulnerable to "mild retracements" in the near term.

"I wouldn't be surprised; the market has rallied hard. Bank of Japan governor Kuroda more than met expectations, there could be some disappointment because he's not going to do that tomorrow," Lewis said.

The Bank of Japan is due to meet on Friday for the first time after it made a monumental shift in policy earlier this month, pledging to pump 1.4 trillion into the economy in less than two years and double its monetary base to meet a 2 percent inflation target by 2016.

(Read More: After 'Shock and Awe,' What Next From the BOJ?)

Aspin of Standard Chartered said another potential trigger for a selloff could be comments by the government or central bank official on containing yen weakness. The Nikkei and the yen have an inverse correlation—a weaker Japanese currency is typically positive for stocks, as heavyweights in the market are mostly exporters which benefit from a weaker currency.

The yen, which has depreciated 10 percent against the U.S. dollar over the past three months, has been hovering just below the key psychological level of 100 for the past two weeks.

(Read More: Is the Hype Over Dollar-Yen at 100 Overdone?)

Independent technical analyst Daryl Guppy believes the market could pull back in the next few days, but said support would likely develop at the 13,500 level, 3 percent lower from current levels. If the Nikkei moves below 13,500 then a fall towards 12,500 cannot be ruled out, he said.

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