Sell-Off Is Clear ‘Warning Shot’ for Nikkei: Pro

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Japanese equities emerged as major laggards in the region on Monday, falling as much as 4 percent after a volatile previous week, raising questions over where the world's top performing market is headed next.

While optimism among Japan bulls appears to be largely intact since last week's sell-off, Kingsley Jones, founder and chief investment officer at investment advisory Jevons Global believes it's time to be "really cautious" on this market. Jones added that he is considering turning short on Japanese equities "in a little while."

The benchmark Nikkei 225 has lost 11 percent since hitting its five and a half year peak of 15,942 last Thursday. However, it still remains up almost 37 percent year to date.

(Read More: Nikkei Goes for Wild Ride for Second Day)

"At 16,000 on the Nikkei, you have really priced in a huge amount of whatever recovery might come," he said, cautioning that the market had gotten far ahead of itself.

According to Jones, it will take 18 months before the positive impact of the massive monetary stimulus announced on April 4 actually shows up in the economy.

He added that the sell-off last week, which resulted in the market's biggest one-day drop in two years on Thursday, was a "warning shot" that money flowing into Japan isn't there for the long haul, and is ready to come out at the first sign of trouble.

"So much can go wrong from a funds flow perspective: when you have a lot of international hot money buying this market in a short space of time, it could just as easily reverse," he said. "As an investor, I would be more comfortable buying Japanese stocks if the rate of returns were much less steep."

Foreign investors have played a central role in driving gains in Japanese equities this year, pumping over $60 billion into the market as of end-April.

(Read More: How Traders Are Playing Turbulent Japan Markets)

Short-Term Correction?

Dhiren Sarin, technical analyst at Barclays, however, believes the long term uptrend in the market is still in place.

"A pullback even towards the 13,000 area would not damage the greater bullish potential. It would bring the market back in pace with a more orderly, rather than accelerating, rise that has been in place since the third quarter 2012 lows," Sarin said.

In the near term, Sarin sees the index headed towards 13,585 – 4 percent lower from current levels.

(Read More: Mammoth Japan Stimulus Still Not Enough: Hayman's Bass)

"This profit taking and sharp setback is largely a result of a crowded market; we are also seeing such signs of profit taking on yen crosses, providing evidence for this short term outlook."

Japan bull Hans Goetti, chief investment officer at Finaport also views the downside in the market as a short term correction.

"There has been some short term technical damage here but as long as the quantitative easing stance by the Bank of Japan isn't changing, we don't change our view on Japanese equities," he said.

However, he cautioned that the biggest risk for the market is Japanese government bond (JGB) yields – which touched a one-year high of 1 percent last week – continuing to rise.

(Read More: Choppy Bond Markets Put Japan Banks on Edge)

"The problem here is what you could have is a crisis of confidence, given the fiscal situation that the Japanese government is in. There could be fears that they will not be able to finance their deficit. That's something we have to watch," Goetti said.

"But for now, central banks have been very good at directing capital into riskier assets – we've seen this in other countries as well. Aggressiveness in Bank of Japan will still lead to higher equity prices in the months ahead," he added.