The Hornets signed Tom Cleverley on loan from Everton until the end of the season, with a view to making the deal permanent in the summer. The former Manchester United midfielder Yones Kaboul helped Watford open the scoring in the 10th minute before Troy Deeney doubled the lead three minutes later.
Alex Iwobi got his name on the scoresheet in the second half as the north London club were trying for their second goal of the match. However, Walter Mazzarri's side were successful in restricting Arsenal from scoring the equaliser.
"I don't think we have a power problem. But we were not mentally ready to deal with the physical duels," Wenger explained, as quoted by the Daily Mail.
"You don't win 47 points after 23 games with no physical power but we have to switch it on 100% in the Premier League. That's what it's about.
"It was obvious we lost duels and were not sharp enough. It looked more mentally that we were not ready for the challenges. We were unlucky for the first goal which was deflected after a soft free-kick."
Wenger, who sat in the stands as he is serving a four-match touchline ban, expressed his disappointment after his side dropped points in the title race. The Frenchman admitted Arsenal were unlucky not to get a point against Watford at the Emirates.
"It took us a while to get into the game, it was all us in the second half and we were unlucky not to get something from the game," the Arsenal manager said.
"I'm responsible for the results so I'm frustrated. What other teams do didn't matter. I'm frustrated we didn't win. We're at home, it's a great opportunity and then we start as we did. We have to learn and respond quickly in a convincing way. Where does it leave the league? We lost today and we want to respond in the next game."