TOKYO (Reuters) - Japan's Nikkei share average struck a three-month closing high on Friday as risk appetite increased after comments from German Chancellor Angela Merkel suggested she supports the European Central Bank's efforts to tackle the euro zone debt crisis.
Expectations of impending action from the ECB to fight the region's fiscal problems and recent stronger-than-expected U.S. economic data have helped the benchmark index rally after it plumbed a seven-week trough on July 25.
The Nikkei index .N225 advanced 0.8 percent to 9,162.50, its highest close since May 8, stopping just short of its 26-week moving average of 9,167.88.
The benchmark closed 3 percent up on the week after surging 3.9 percent last week to log its best weekly gain in six months, helped by Merkel's comments that ECB chief Mario Draghi's vow to do all that is necessary to defend the euro is in line with what European leaders have been saying.
"This rally is being driven by hedge funds getting out of the very short positions they got into last month when Europe wasn't coming up with any policy decisions," said Takashi Oba, senior strategist at Okasan Securities.
"On the surface the gains may look impressive, but they're empty. There's no new money in the market, it's just being pulled out of bonds."
Some analysts are wary of low volumes, customary in the summer holidays, distorting the market and setting it up for a sharp fall in September when more players return to trade amid a flurry of significant events in the euro zone.
The value of shares traded on the first section of the Tokyo Stock Exchange, which mostly includes the large caps, failed to rise above 1 trillion yen on four days out of five this week, including Friday.
Nevertheless, investors scrambling to cover their short bets triggered a risk-on atmosphere, with economically-sensitive sectors such as iron and steel .ISTEL.T striding ahead 3.8 percent while defensive food and pharmaceutical companies underperformed, dropping 1.2 and 0.5 percent respectively.
"Over the past couple of days, I raised the weighting of cyclical stocks, such as electronics parts, semiconductors and auto parts," said Yasuo Sakuma, portfolio manager at Bayview Asset Management.
Sakuma added that the Nikkei could test 9,500 by early September but added it was unlikely to go higher as doubts remain about a slowdown in the global economy.
Japan Tobacco Inc (2914.T) dropped 3.7 percent after China's health ministry said it plans to ban cigarette advertising and promotions and to hike taxes, a double blow for the tobacco industry after Australia's High Court ruled on Wednesday that cigarettes will be stripped of branding and sold in plain packs.
Japan Tobacco's share price fell 4.8 percent on that day, but rebounded 5.5 percent on Thursday as investors realized the company's exposure to Australia was relatively low, according to a trader. However, China's decision cements a widening international clampdown that could hurt sales, he added.
Beleaguered consumer electronic company Sharp Corp (6753.T) enjoyed a brief bounce, rising as much as 13.1 percent after the Nikkei business daily said that Taiwan's Hon Hai Precision Industry (2317.TW) was seeking to more than double its stake in Sharp to 20 percent, a report that Sharp denied.
Hon Hai reportedly said it would pay 200 yen per share, down from the 550 yen initially agreed in March when a 9.9 percent share was set. Sharp was up 5.1 percent at 184 yen at the bell, after which Jiji news agency said the company was seeking a 50 billion yen capital increase from companies including Toshiba Corp (6502.T) and Kyocera Corp (6971.T).
Japanese exporters were the beneficiaries of a softer yen, which traded at 79.36 yen to the dollar, near a one-month low of 79.40 touched on Thursday.
The broader Topix .TOPX index put on 0.9 percent to 765.81, marking a one-month closing high, still 2.1 percent off July 4's two-month high of 781.94.
However, the price-to-earning ratio of Topix shares were lifted to 11.1 from last week's four-year low of 10.42 by the recent rally, data from Thomson Reuters Datastream showed.
Domestic retail investors were net sellers of Japanese stocks last week for the first time in five weeks. Jun Yunoki, equity analyst at Nomura Securities, said he expected they would continue to offload their positions into September as they had been buying on dips for some time.
"They have been building a lot of long positions in margins and these margins have to be paid back in six months. The six-month comes around September. If the market rises, it gives them a chance to unload these long positions," he said.
Additional reporting by Dominic Lau; Editing by Sanjeev Miglani