Led by exporters and financials, the Nikkei ended 237.39 points higher at 10,160.40 in heavy volume, ahead of the conclusion of the Bank of Japan's two-day meeting on Thursday. Sources said that the central bank will take further easing steps to support growth, with data on Wednesday showing that exports fell for a sixth straight month in November from a year ago.
The benchmark Nikkei has rallied 17.3 percent over the past five weeks, spurred by the yen weakness after Shinzo Abe, who was elected as the next prime minister on Sunday, called for the Bank of Japan to adopt aggressive policy action, including embarking on "unlimited easing" and setting an inflation target of 2 percent, to kick-start the ailing economy.
But many foreign investors, who have missed the early part of the rally as they are underweight on Japan, were being forced to dip into the market, likely further supporting the rally. "Investors are pouring in new money and expanding their 'hot picks' from exporters to other sectors," said Naoki Fujiwara, a fund manager at Shinkin Asset Management.
The latest fund manager survey by the Bank of America Merrill Lynch showed global asset managers were not as downbeat on Japanese equities as in the previous month, with a net 17 percent planning to be underweight on Japan in the next 12-month versus 39 percent in November. According to Reuters data, the most traded January Nikkei index options were a call with a strike price of 10,500 , 3.3 percent above where the index ended on Wednesday. The next most-traded was another call at 10,750, followed by another call at 9,500.
But Wednesday's hefty gains took the index deeper into "overbought" territory, with its 14-day relative strength index at 85, way above 70 which is considered overbought and often signals a possible near term pull back. Technical charts also showed the Nikkei has risen further above the upper band of the momentum indicator Bollinger Bands, signalling the index is thought to be overbought and triggered a 'sell' signal.
The index is up 20.2 percent this year, outpacing a 15 percent gain in the US S&P 500 and a 14.7 percent rise in the pan-European STOXX Europe 600. The broader Topix index climbed 2.8 percent to 839.34 in active trade on Wednesday, with 4.03 billion shares changing hands, its highest since March 2011. Exporters led the charge higher included Canon Inc, Ricoh Ltd, Toyota Motor Corp and Honda Motor Co, up between 3.5 and 9.1 percent.
"You are seeing a lot of short-covering today ... in the likes of Ricoh, Canon," a senior dealer at a foreign bank said. Short-selling interest in Canon has risen sharply, with 27.68 percent of its stock that is available to be borrowed out on loan as of December 17, up from 9.7 percent on November 30, according to data provider Markit. The figure was 80.11 percent for Ricoh as of Monday.
Financials were also in demand as investors expected the sector would benefit from any reflation push by the Abe administration. Mitsubishi UFJ Financial Group surged 6.1 percent and was the most traded stock on the main board by turnover, Sumitomo Mitsui Financial Group advanced 4.2 percent and Mizuho Financial Group gained 4.3 percent, while Nomura Holdings Inc, Japan's top brokerage, rose 4.7 percent. Mizuho and Sumitomo Mitsui Financial Group were the fourth-and fifth-most traded, respectively. Insurers jumped 6.2 percent as the rally in stocks would boost the value of their equity holdings.