TOKYO The Nikkei share average climbed to a seven-month closing high above the 9,500 mark on Thursday, encouraged by a yen kept weaker through persistent speculation that the central bank would adopt bolder action to pull Japan out of deflation under a likely new government.
The Nikkei rose 0.8 percent to 9,545.16 points, the highest closing level since April 26.
But Thursday's rally took the index to "overbought" territory, with its 14-day relative strength index at 70.4. Seventy or above is deemed overbought, which often signals a possible pull back in the near-term, analysts said.
"When the market falls, it attracts buying soon, but when it starts rising again, investors take profits. Unless there are more clear developments which would convince foreigners that the BOJ will take action for monetary policy, it will be difficult to see stable gains," said Shun Maruyama, chief strategist at BNP Paribas, adding that foreigners were unlikely to take big positions before they go on Christmas holidays.
Japan's conservative Liberal Democratic Party (LDP) looks on course to win a surprisingly solid majority in a December 16 parliamentary election, media polls showed on Thursday, returning to power with a hawkish former premier at the helm.
Former Prime Minister Shinzo Abe, who heads the LDP and would likely return to the top job if the party wins, is calling for radical monetary easing by the Bank of Japan (BOJ) to beat persistent deflation and a strong yen.
His comments have weakened the yen over the past three weeks, while the Nikkei has rallied 10.2 percent, led by exporters.
But analysts said the path to softer monetary policy does not seem smooth.
"Even if the LDP wins a majority in the lower house, it will not have one in the upper chamber, so it will be difficult to pass legislation," said Hiroyuki Fukunaga, the chief executive of Investrust.
"For example, the LDP supports public works, which lifted construction sector when Abe called for more public works, but the DPJ is against it. Investors take a cool stance on Japan's political developments now."
But other market observers said that the mood remained positive on the back of the weak yen, and if trading volumes also pick up the Nikkei may rise further towards next year on a combination of both domestic and overseas factors such as a resolution of U.S. budget problems.
"We expect the avoidance of the fiscal cliff in the U.S., improvement in the revision index accompanying yen weakness and a bottoming in the domestic economy to drive gains in Japanese equities through spring 2013," Citigroup wrote in a research note, adding that it expects the Nikkei to reach 9,900 and the Topix to hit 820 then.
The broader Topix advanced 0.9 percent to 788.74, in fairly high volume, with 2.0 billion shares changing hands in versus 1.84 billion for Wednesday and last week's daily average of 2.01 billion.
Foreign investors were net buyers of Japanese equities last week for the third straight week. They bought a net 184.3 billion yen of shares in the week through December 1, down from 275.8 billion yen in the previous week, finance ministry data showed.
Exporters in demand included Toyota Motor Corp (7203.T), camera and printer maker Canon Inc (7751.T), air conditioner maker Daikin Industries Ltd (6367.T) and Honda Motor Co, up between 1.0 and 3.1 percent.
The yen was quoted at 82.40 to the dollar after falling 0.7 percent to 82.46 yen on Wednesday. It touched a 7-1/2-month low of 82.84 yen to the dollar on November 22.
Sharp Corp surged 9.9 percent to a 2-1/2 month high after a Taiwan newspaper quoted the chairman of Hon Hai Precision Industry as saying that Qualcomm's tie-up with the struggling TV maker will not affect Hon Hai's talks with Sharp to become its biggest shareholder.
Hon Hai's chairman reiterated that he expects to reach a decision with Sharp before March 2013, the newspaper reported.
Adding to the positive mood, sentiment among Japanese manufacturers edged up for the first time since July, a Reuters poll showed, in a sign that the economy may have bottomed out even as sluggish global demand continues to weigh on business confidence.
The benchmark Nikkei is up 12.9 percent this year, in line with a 12.1 percent rise in the U.S. S&P 500 and a 13.2 percent gain in the pan-European STOXX Europe 600.
But Japanese equities are more expensive than their European peers, with a 12-month forward price-to-earnings ratio of 12.1 versus STOXX Europe 600's 11.1, data from Thomson Reuters Datastream showed. The S&P 500 has a 12-month forward P/E of 12.5.
(Additional reporting by Dominic Lau and Antoni Slodkowski; Editing by Edwina Gibbs & Kim Coghill)