The Nikkei average fell a third straight day, reaching a three-week closing low on Wednesday after the Bank of Japan's easing steps fell short of expectations, triggering profit-taking in shares bought in anticipation of the central bank decision.
Shippers, steelmakers, securities and insurance companies dropped , along with exporters, as the Japanese currency firmed by nearly one yen to 88.33 yen against the dollar from Tuesday's market close of 89.28 yen.
"The big event is over now. Investors are shifting their focus to corporate earnings and the US economy, so they'll be cherry-picking individual stocks," said Naoki Fujiwara, chief fund manager at Shinkin Asset Management.
The Nikkei dropped 2.1% to 10,486.99, logging its biggest one-day percentage fall in a week. Wednesday's retreat took the index further from its 32-month high of 10,952.31 on January 15.
Analysts said that investors were disappointed that there could be no action this year after the central bank on Tuesday pledged open-ended asset purchases starting from 2014 and set a 2% inflation target.
"The central bank is basically announcing what it plans to do next year while it says it will stay 'hands off' for now. Can the market approve that? Of course not," said Norihiro Fujito, a senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities.
He added that as soon as the BOJ announcement was out, the securities firm started receiving calls from European investors who were awake early and asking it to prepare to sell stocks and buy the yen.
But many market players said a sell-off should be limited because investors are positioned for further gains in the stock market as most expect BOJ Governor Masaaki Shirakawa, whose term ends in April, to be replaced by someone whose stance on aggressive policy easing matches Prime Minister Shinzo Abe's.
Abe has made clear that he wants a BOJ governor who shares his push to reflate the economy with a hyper-easy monetary policy combined with big fiscal spending.
Before the BOJ meeting, the Nikkei had gained around 25% since mid-November, when then-incoming leader Abe began calling for a softer yen and easier monetary policy.
On Wednesday, the sea transport sub-index was the top sector loser, dropping 5%. The securities sector lost 4.3% while the iron and steel sector fell 3.3%.
Exporters, whose overseas earnings increase when the yen is soft, succumbed to profit-taking, with Mazda Motor Corp falling 3.7%, Nikon Corp dropping 3% and Nissan Motor Co Ltd shedding 2.8%.
Market still overbought
Market observers also noted that a correction is natural and should cool down the "overbought" market.
"Some investors have been waiting for the timing to take profits, as they have chased the market higher," said Hiroichi Nishi, assistant general manager at SMBC Nikko Securities.
Some technical charts show that the stock market is 'overbought", including the toraku ratio, or up-down ratio, used for the first section of the Tokyo Stock Exchange, which was at 139.5. The ratio is calculated by dividing the 25-day moving average of stocks that gained by the 25-day average of those that fell. A level above 120 signals an overheated market.
They added that a correction could pull down the market to around its 25-day moving average of about 10,355, or 1.3% below Wednesday's close.
Among Wednesday's losers, TDK Corp fell 4.2% to a three-week closing low after the Nikkei business daily said the hard-disk drive and electronic parts maker was expected to report a 30% fall in operating profit for October-December due to weak demand for smartphone parts.
The broader Topix dropped 1.5% to 887.79 in relatively thin trade, with 3.38 billion shares changing hands, slightly lower trading volume than last week's daily average of 3.73 billion shares.