The Nikkei stock average fell 2.4 percent on Wednesday as investors sold Toyota Motor Corp (7203.T) and auto-related stocks after the world's biggest automaker forecast its first-ever annual operating loss.
Further deterioration in the U.S. housing market and worry over about weak consumer spending in the final stretch of the Christmas season hurt sentiment.
Tokyo shares were also pressured by position squaring ahead of a switch to a paperless share system in Japan in January.
Toyota slid 4 percent and tire giant Bridgestone Corp (5108.T) tumbled nearly 5 percent after both companies slashed their outlooks on slumping vehicle demand amid the global recession.
"Coupled with a fall on Wall Street, Japan's economic fundamentals are bad and so are corporate earnings, including those of Toyota and Honda," said Fumiyuki Nakanishi, manager at SMBC Friend Securities.
"But losses appear to be limited as I think the market expects to see a New Year rally in the U.S. on hope for the new administration after investors return from the Christmas holidays."
The benchmark Nikkei .N225 dropped 206.68 points to 8,517.10, after rising 1.6 percent on Monday to book its highest finish since Nov 11. Japanese markets were closed on Tuesday for a national holiday.
The broader Topix declined 2.6 percent to 826.99.
Hideyuki Ishiguro, supervisor for Okasan Securities' investment strategy department, said the Nikkei could rise toward 10,000 in January or February, supported by hopes for U.S. economic stimulus measures.
U.S. President-elect Barack Obama is expected to unleash a massive government spending program when he takes office in January.
A Reuters poll showed that Japanese retail investors turned slightly more pessimistic about domestic equities in December, but just over half expect Tokyo shares to bottom out by the middle of next year.
Besides auto-related stocks, shares in financial institutions slid, with the banking-sector subindex falling 5.2 percent .IBNKS.T after rising for four straight days.
Investors probably squared positions in some shares that will be affected by a temporary trading suspension related to the launch of a paperless share system in January, said a trader for a Japanese brokerage house, adding that such position unwinding likely hurt some banking shares.
Trade in 14 stocks listed on the Tokyo Stock Exchange including NTT (9432.T) and Mizuho Financial Group (8411.T) will be suspended from Dec 25 to Dec 30 and will resume on Jan 5, according to the bourse.
Besides Mizuho, banking shares subject to the trade suspension include industry heavyweights Sumitomo Mitsui Financial Group (8316.T) and Resona Holdings Inc (8308.T).
