TOKYO (Reuters) - Japan's Nikkei share average shed 1.1 percent on Thursday, closing out its worst monthly fall in two years as investors cut exposure to risky assets on deepening concerns over Spain and its banking sector, with exporters taking a beating.
The Nikkei .N225 fell 90.46 points to 8,542.73, cutting earlier losses amid talk from traders that the Bank of Japan was buying exchange-traded funds in the afternoon to support the market.
Still, the benchmark hit a 4-1/2-month closing low and was down 10.3 percent in May, its biggest one-month fall since May 2010, when it lost 11.7 percent.
"A slight sense of panic emerged last night in the U.S. market with stocks being sold off and investors buying bonds and yen," said Kenichi Hirano, operating officer at Tachibana Securities.
"If the speed of that selling is curbed we should see short-covering and investors buying stocks back, or even new investments."
Technical indicators showed the Nikkei could be ripe for a rebound, as it is back in "oversold" territory, with its 14-day relative strength index at 29.8. The short-selling ratio has reached 28.3 percent so far in May, its highest since August 2002 and within the range of 28 to 30 percent when short-covering tends to emerge.
A poll of 12 Japan-based institutional investors showed the average weighting for domestic equities jumped to 37.1 percent from 30.8 percent last month, benefiting as Europe's deepening debt woes reduced the appeal of up and emerging market equities.
By contrast, a year ago Japanese stocks accounted for only about a quarter of their equity portfolios.
Foreign investors were downbeat, however. Data from the Ministry of Finance showed foreign investors sold a net 112.7 billion yen ($1.43 billion) of Japanese stocks last week, the sixth straight week of net selling.
"We are at the mercy of macro events," said Stefan Worrall, director of equity cash sales at Credit Suisse in Tokyo.
"If we go below that dollar/yen level (before the BOJ unexpectedly eased policy on February 14), it will be very difficult for the Nikkei when the yen is strengthening aggressively." The yen hit a 3-1/2-month high against the dollar.
Power utilities outperformed, however, after Prime Minister Yoshihiko Noda said on Wednesday it was necessary to restart idled nuclear reactors that have been confirmed safe to avoid a summer power crunch.
Chubu Electric Power Co (9502.T) led the pack, surging 6.4 percent, while Kansai Electric Power Co (9503.T), Shikoku Electric Power Co (9507.T) and Hokkaido Electric Power Co (9509.T) climbed between 3.2 and 5.8 percent.
The broader Topix .TOPX shed 0.6 percent to 719.49. The index is down 0.4 percent this week, and if it were to end the week lower, it would mark its worst weekly losing run since 1975.
The recent sell-off has taken the Topix's 12-month forward price-to-earnings ratio to 10.9, a level not seen since November 2008, data from Thomson Reuters Datastream showed.
"In an absolute worst-case scenario the uncertainty surrounding the euro zone's future could trigger another financial panic and push the Nikkei down to 7,500," Hirano said. "That would bring its average price-to-earnings ratio from 11 now to about 9.5, the same as after the Lehman shock in 2008."
Trading volume on the main board hit a 2-1/2-month high, with 2.31 billion shares changing hands, up from Wednesday's 1.62 billion shares and last week's average of 1.66 billion.
Nomura Holdings (8604.T), Japan's top investment bank, fell 1.9 percent, partly damaged by fears of contagion from Spain's ailing banks and an insider trading scandal. The banking sector.IBNKS.T fared better, easing 0.6 percent.
Naoki Kamiyama, chief equity strategist at Deutsche Bank, was upbeat on Japanese banks, saying they had been battered by the euro zone crisis even though they had no or little exposure to Greece and other highly indebted European countries.
"I'm positive on financials at this moment for sector allocation. Financials include banks and real estate," said Naoki Kamiyama, chief equity strategist at Deutsche Bank.
"This is a kind of value situation because of the European financial turmoil, which is not fundamentally affecting Japanese banks. It's just cheap. It's just a sentiment driven issue."
The banking sector .IBNKS.T carried a 12-month forward P/E of 7.64, much cheaper than the Topix, Datastream data showed.
Additional reporting by Sophie Knight; Editing by Richard Pullin