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The Sun Will Rise: Why Investors Still Love Japan

A businessman walks in front of a digital share prices display board in Tokyo, Japan.
Yoshikazu Tsuno | AFP | Getty Images
A businessman walks in front of a digital share prices display board in Tokyo, Japan.

Investors in the Japanese and U.S. stock markets may end up nursing the same hangover in 2014, but for now they probably won't let a little lull spoil the party.

Now that the Nikkei 225 has cooled a bit, questions are arising over whether the index's nearly 70 percent surge over the past year has gotten overdone.

The simple answer is that while Japanese equities could be in for a brief pause, the buy-the-dip mentality remains firmly in place.

(Read More: Rallies End Sometime, but This One May Not End Soon)

"When you're up 60 percent in seven months you're going to have a bit of a pullback, that's to be expected," Erik Davidson, deputy chief investment officer at Wells Fargo Private Bank, said in an interview. "Most U.S. investors are underexposed to Japan. That's a big, big risk."

The meteoric surges in both the Nikkei and the U.S. stock markets are underpinned by the same dynamic: Massive central bank stimulus that while only marginally helping economic growth has pushed asset prices skyward.

Japan stocks sustained a shock May 22 when a surge in yields of Japanese Government Bonds—JGBs—along with weak Chinese economic data and fears that the Federal Reserve might pull the plug early on its asset purchase program sparked worries that the rally was coming to a close.

(Read More: Here's How The Party Will End If The Fed Pulls Back)

Most Wall Street strategists, though, remain bullish on Japan.

"If they can turn the corner on deflation, the implications from a confidence perspective, from a competitive perspective, from a domestic demand perspective can be huge," Davidson said.

Investors haven't been shy about Japanese equities and continue to be buyers despite the recent pullback.

The two most popular exchange-traded funds this year both focus there.

(Read More: Forget the Volatility, Nikkei May Test 17,000: Chart)

The WisdomTree Japan Hedged Equity fund—popular because it hedges against yen weakness that has come with monetary easing—has taken in $7.74 billion of assets in 2013 and is up 44 percent over the past six months.

The iShares MSCI Japan fund has pulled in $5.73 billion and has gained 21 percent over the past six months despite losing 9.4 percent in just the past five days.

Bullish sentiment on Japan largely rests on confidence that Prime Minister Shinzo Abe's economic reforms will spark growth.

"We are bullish on Japanese equities for three reasons," Citigroup analyst Kenji Abe said in a note to clients. "(1) We expect the economy and corporate earnings to continue recovering as the effects of Abenomics materialize in full. (2) The political environment looks conducive to Abenomics being continued for the next three years. (3) The US economy is looking stronger than it did before the Lehman crisis."

Business funding activity has surged in Japan this year, with debt capital market volume at $41.5 billion, the highest in 15 years and 28 percent greater than the same period in 2012, according to Dealogic.

(Read More: Here's How QE Tapering Could Hurt Asia)

As for the rising debt yields, most strategists dismiss it as a product of greater economic activity and a natural outgrowth of central bank easing.

"To the extent that the increases reflect higher expectations for inflation, it might actually be deemed a sign of success, and the real interest rates that matter more for investment decisions and the public debt burden could still be lower than otherwise," Julian Jessop, chief global economist at Capital Economics, said in a report

"We would be more concerned if JGB yields rose as a result of a surge in yields overseas, or a loss of credibility on fiscal policy," he added.

As for the long term, the picture may not be so rosy.

Japan faces a number of roadblocks, not the least of which is a rapidly aging population, and may have to pay later for its stimulus measures now—much the same as the U.S.

"I don't think we're near the end (of the rally) yet," Richard Harris, chief executive of Port Shelter Investment Management, said in a CNBC interview. "Looking at the rest of the year, maybe into 2014, the market reacting to liquidity is quite reasonable timing.

"But we're going to have to ask some very big questions maybe in the first quarter of 2014 as to exactly where we go from here."

By CNBC's Jeff Cox. Follow him on Twitter at @JeffCoxCNBCcom.