By Sophie Knight
TOKYO (Reuters) - Japan's Nikkei share average fell 2.6 percent on Wednesday, its biggest one-day drop in eight months, as a rebound in the yen prompted investors to take profits on recent outperformers such as shares of exporters.
The Nikkei lost 278.64 points to 10,600.44, toppling from a 32-month high hit on Tuesday. It also dropped out of "overbought territory", with its 14-day relative strength index coming back under the 70-mark for the first time since December 21.
Toyota Motor Corp <7203.T> fell 2.6 percent, Canon Inc <7751.T> dropped 4.1 percent and Fanuc Corp <6954.T> shed 4.3 percent.
The yen, which has fallen more than 1 percent against the dollar so far this year, rebounded for a second day on Wednesday after a government official said further softness in the yen could harm importers and fuel costs, adding to similar comments from another minister this week.
Shigeru Ishiba, secretary general of the Liberal Democratic Party, said that it is desirable for the dollar to trade at around 85 yen to 90 yen. The dollar last traded 88.11, pulling away from a 2-1/2-year high of 89.67 set on Monday.
"Both these comments seemed to be the first time that there was an element of a pushback to the surprisingly singular and consistent message from Abe," said Stefan Worrall, director of equity cash sales at Credit Suisse in Tokyo.
The Nikkei has rallied about 24 percent over the past two months, spurred by weakness in the yen after Japan's new leader Shinzo Abe called on the Bank of Japan to adopt aggressive policies to energise the ailing economy, including setting an annual inflation target of 2 percent.
A survey by Bank of America Merrill Lynch found that a net 3 percent of foreign investors are now overweight on Japanese equities, a 23 percent increase from last month, while a net 4 percent said the outlook for Japanese corporate earnings was now favourable, up 22 percent from December.
However, increased enthusiasm for the Japanese market has left it looking overheated, with its shares looking expensive in comparison with other markets.
Japanese equities carry a 12-month forward price-to-earnings ratio of 13.1, above the U.S. S&P 500's <.INX> 12.9 and the pan-European STOXX Europe 600's 11.6, data from Thomson Reuters Datastream showed.
Traders said that a pause in the yen's weakening trend triggered selling in shares that had gained recently, which could drag the index below the 10,500-mark in the coming days.
Shares of Boeing Dreamliner suppliers in Japan came under pressure after All Nippon Airways Co <9202.T> grounded all 17 of its Boeing
GS Yuasa Corp <6674.T> lost 4.5 percent, while Fuji Heavy Industries <7270.T> and Mitsubishi He7011./avy Industries <7011.T> and IHI <7013.T> were down between 2.9 and 4 percent. ANA fell 1.6 percent.
Heavyweight Fast Retailing Co Ltd <9983.T> also dragged, shedding 4.6 percent after Goldman Sachs downgraded the Uniqlo store operator, saying its earnings outlook was already sufficiently priced into the share price.
Fast Retailing had gained 4.6 percent between November 15 and Tuesday's close.
Among other losers, securities firms, which have been beneficiaries of the strong market, also succumbed to profit-taking. Nomura Holdings <8604.T> fell 2.8 percent and Daiwa Securities Group <8601.T> slipped 4.3 percent.
WILL THE BOJ STEP IN?
The broader Topix lost 2 percent to 888.11, prompting expectations that the BOJ would buy more exchange-traded funds (ETFs) to support the market, as it has customarily done in the past when the index falls below 1 percent in the morning session.
The BOJ, which will hold its policy review on January 21-22, last purchased ETFs on November 8 last year but is widely expected to further increase buys of assets such as government bonds.
"It will be an interesting test in the sense that maybe they're kind of happy with how far it's gone already and (they feel like) their job is sort of done," Worrall of Credit Suisse said.
(Additional reporting by Ayai Tomisawa, Tomo Uetake; Editing by Kim Coghill)