By Dominic Lau
TOKYO (Reuters) - Japan's Nikkei average fell on Tuesday as investors were cautious ahead of the German constitutional court's ruling over the legality of the European bailout fund on Wednesday and the U.S. Federal Reserve policy meeting this week.
The Nikkei dropped 0.8 percent to 8,800.35, holding above the support level of its five-day moving average at 8,780.35.
Cyclical stocks, which have a relatively high correlation to the health of the economy, came under pressure, with industrial robot maker Fanuc Corp <6954.T> down 0.9 percent, Honda Motor Co <7267.T> off 1.2 percent and Toyota Motor Corp <7203.T> losing 2 percent.
"The possibility of QE3 is getting higher. However, if the QE3 were to (be announced) ... all the good news has been discounted," said Yasuo Sakuma, portfolio manager at Bayview Asset Management.
Investors have had high hopes that the Fed will announce another round of stimulus after it concludes a two-day meeting on Thursday.
"If the QE3 were to be introduced, the pressure of a stronger yen will not be necessarily good news for the Japanese stock market," Sakuma said, adding that he had increased his positions slightly in cyclical stocks such as financials and capital goods, as well as his cash holdings.
Germany's constitutional court holds the fate of the euro in its hands when it rules on Wednesday whether the European Stability Mechanism (ESM) can go ahead, after already holding it up for several months.
Technology stocks extended their losses after Intel Corp
Shinko Electric Industries <6967.T>, Ibiden Co Ltd <4062.T>, Tokyo Electron Ltd <8035.T> and Renesas Electronics Corp <6723.T> were down between 1 and 1.3 percent.
Japan Tobacco Inc <2914.T> rebounded 1 percent after slumping 8.4 percent in the previous two sessions on concerns over more regulation in Europe, after the French government said it was looking at raising tobacco prices as part of a push against smoking.
The broader Topix index lost 0.9 percent to 730.39.
The Nikkei is up 4 percent so far this year.
Barclays Securities said global equity prices were expensive relative to the real economy.
"A comparison of year-on-year growth suggests that the Nikkei average and S&P 500 <.INX> are 10 percent and 20 percent rich, respectively, relative to Japanese and U.S. manufacturing indexes," it said in a note.
"Assuming this discounts additional monetary easing in the U.S. and Europe, and progress on the euro zone debt situation, we see a good chance of a significant correction in share prices within the next three months."
Barclays Securities said any rise in Japanese government bond yields would be short-lived. Yields on benchmark 10-year JGBs were quoted at 0.800 percent on Tuesday.
(Editing by Edmund Klamann)