The Nikkei average resumed falling on Thursday following a rebound the day before, after rumours about the health of French banks re-ignited concerns over the euro zone's debt crisis, but declines were limited by a rise in U.S. stock futures.
Carmakers such as Nissan Motor , which slumped 3.5 percent, were among the hardest hit as funds continued their shift into domestic-demand related and defensive sectors like pharmaceuticals and retail, on worries over the global economy and the strong yen.
Banks and other financials, already trading well below book value, also dipped after rumours about the financial health of Societe Generale , which the bank denied, triggered a selloff in European and U.S. banks.
"European problems are not directly related to Japanese banks and have not originated here, so we didn't see a sell-off in these stocks today," said Yuuki Sakurai, CEO and president of Fukoku Capital Management, whose company manages around $8 billion in assets.
"I'm not pessimistic about Tokyo stocks, especially looking at domestic-demand related ones which will benefit from the post-quake recovery, but we need to wait until oversees markets calm down. Right now it's hard to buy anything even on dips."
The benchmark Nikkei average closed down 0.6 percent at 8,981.94, while the broader Topix shed 0.8 percent to 770.88. The indexes trimmed initial losses after U.S. stocks futures climbed 1.5 percent.
Support for the Nikkei looms at 8,639.56, its intraday low hit on March 17.
Echoing Sakurai's comments, other institutional fund managers were mostly confident about assets and some have been trying to position their portfolios to gain when equities bounce and bond yield spreads over Treasuries tighten.
The Nikkei is hovering some 11 percent off its post-quake closing high hit on July 8, after investors sold equities due to concerns about the health of the global economy and debt woes in the United States and Europe.
Reflecting those concerns, foreign investors sold Japanese stocks for the second straight week in the week ended Aug. 6. They stepped up their selling to a net 390 billion yen ($5.1 billion), the largest amount since June 2010, Ministry of Finance data showed.
Volume was steady with some 2.2 billion shares changing hands on the main board, a bit above last week's daily average of 2.0 billion shares.
BANKS' DECLINES LIMITED
"Losses in Japanese banks are limited because they started falling from levels that were already much lower than their overseas peers," said Hiroaki Osakabe, a fund manager at Chibagin Asset Management in Tokyo.
Mitsubishi UFJ Financial Group , Japan's largest bank by assets, fell 1.9 percent to 357 yen, while Sumitomo Mitsui Financial Group dropped 1.8 percent to 2,225 yen on relatively steady volume. Both banks were missing from the top four most-actively traded stocks by turnover on the main board.
By comparison, the index of European banks dropped 6.7 percent, while Bank of America Corp and Goldman Sachs both fell more than 10 percent.
"Japanese banks aren't as exposed to the peripheral debt as European banks, but they can still suffer contagion if there's any sort of financial crisis again," said a trader for a U.S. brokerage who did not want to be named.
"If we're going to see a sustainable bounce, it's going to be led by real estate, brokers and banks to a certain extent. But until we see price action there, and I don't see it coming, then people will sell into any of those short-term rallies."
Another factor supporting the Nikkei was the strong presence of retail investors, who covered their short positions in red-hot Internet stocks.
Gree Inc , a social networking service operator, rocketed to another all-time high in heavy trade. It rose 7 percent to 2,185 yen, boosted by earnings results and forecasts that beat market expectations.
This week the stock has gained more than 20 percent, compared with the Nikkei's near 4 percent slump. Rival DeNA rose 3.8 percent to 3,945 yen.