The Nikkei average dropped 2.81 percent to end below 17,000 for the first time in nearly a month on Monday as a sharp rise in the yen dimmed the profit outlook for exporters such as Toyota Motor Corp.
Analysts said a lower house by-election on Sunday, when an opposition candidate beat one backed by the ruling Liberal Democratic party (LDP), also weighed on the market, raising concerns about political uncertainty.
The dollar tumbled to a three-month low against the yen on Monday after the Group of Seven said China should let the yuan appreciate as a way of fixing global trade imbalances.
"There had been expectations of bright profit prospects for technology exporters as the earnings season swings into high gear this week. But the yen's sharp gains are dashing such hopes and raising questions about the outlook," said Hiroichi Nishi, general manager of equity marketing at Nikko Cordial Securities Inc.
Takashi Miyazaki, general manager of the investment strategy division at Mitsubishi UFJ Partners Asset Management, also said the market will likely remain sluggish.
"The high yen, high oil prices and the election result all hit the market when stock valuations were already high and trade volume was thin," he said.
"Corporations will likely produce conservative outlooks at their earnings announcements and they will not likely provide a chance for the market to turn around and head north," he added.
The Nikkei average finished down 489.56 points at 16,914.40, breaking below 17,000 for the first time since March 29. The benchmark also booked the largest one-day percentage loss since January 18, when an investigation against Internet firm Livedoor Co on suspicion of violating securities laws triggered sharp sell-offs in the market.
The TOPIX index was down 2.60 percent, or 45.64 points, at 1,710.76. Tsuyoshi Segawa, an equity strategist at Shinko Securities, said the election particularly interested the market because Prime Minister Junichiro Koizumi, who is popular with foreign investors, step downs in September and the ruling party will have to fight an upper house election next year without him.
Depending on who succeeds Koizumi, skittish investors could be prompted to sell shares, Segawa said. "Foreign investors are focusing on whether the new prime minister will follow up Koizumi's reform agenda," he said. Auto stocks took a beating on the yen's rise as a higher yen eats into exporters' profits overseas when they are brought home.
Toyota Motor, the world's second-biggest auto maker, declined 2.8 percent to 6,710 yen, off a lifetime high of 6,950 yen marked on Friday. Honda Motor Co Ltd, which fell 3.7 percent to 7,820 yen, had hit a record high of 8,210 yen on Friday, making it vulnerable to profit-taking.
In the technology sector, Canon Inc, the world's top maker of digital cameras and which generates three-quarters of its sales outside Japan, was down 2 percent at 8,650 yen. Consumer electronics giant Sony Corp lost 2.9 percent to 5,970 yen.
NEC Corp tumbled 4.5 percent to 834 yen and NEC Electronics Corp fell 5.2 percent to 4,400 yen after profit warnings. NEC cut its profit estimate for the business year ended in March after its microchip unit, NEC Electronics, forecast bigger losses due to appraisal losses and potential payouts in lawsuits.
A few bright spots included baby food maker Wakodo Co which jumped 18.6 percent to 6,380 yen after Asahi Breweries Ltd, Japan's biggest beer maker, said it would launch a tender offer of up to 47 billion yen to take a controlling stake in Wakodo. Asahi Breweries ended down 2.7 percent at 1,697 yen.
Merrill Lynch equity strategist Masatoshi Kikuchi said in a report on Monday he maintained his fiscal year to March 2007 fair value estimate for TOPIX at 1,800 but expects the index to fall in the summer.
"The TOPIX index should do well until around June, but then pull back in the summer on political and policy factors before recovering late in the year," he said.
Kazunori Otomo, president at Otomo Investment Management Ltd, said he would remain cautious until the summer to see how the end of the Bank of Japan's ultra-loose monetary policy would affect the stock market.
Otomo said nearly 30 trillion yen worth of funds will be taken out of the banking system as a result of the policy shift. "You have to think twice about the amount," he said. "Would investors still buy stocks? We have to wait and see."
Meanwhile, after the market closed, Kao Corp, Japan's biggest household products maker, reported a 1.4 percent fall in net profit for the latest business year but forecast a small gain in the current year and profit to start rising again in 2007-08.
Kao ended down 2.9 percent at 3,020 yen.
Trade rose to its most active level in more than a week, with 1.82 billion shares changing hands on the Tokyo exchange's first section. Declining stocks overwhelmed advancers by a ratio of nearly 20 to 1.