A batch of economic reports that just weren't good enough added to the mix as the major indexes all fell about 2 percent and the Dow Jones industrials slid 185 points. Treasury prices, usually the beneficiary of a slide in stocks, ended only moderately higher.
A break in the market's rally was widely expected because pressure to sell has been building for some time. While the major indexes finished August with respectable gains, including a 3.4 percent rise in the Standard & Poor's 500, trading was erratic and there was little conviction behind the advances. Analysts warned that investors were doubting whether they should have bid stocks so high in the rally that began six months ago.
So it wasn't surprising that, after the Dow was up 60 points in response to a seemingly better-than-expected reading on manufacturing, something like a rumor about a possible bank failure could take the market down.
"Some time midmorning, rumors came out that a large bank could be in trouble," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. "That's all it takes to spook this market."
The Dow's drop virtually equaled a 186-point slide two weeks ago that the market later recovered from, sending stocks to their highest levels in almost 10 months. Dan Deming, a trader with Strutland Equities in Chicago, said it didn't appear much had changed in the market since then, but investors have grown more nervous as stocks have pushed higher and that was enough to tip off heavy selling.
"It's really more psychological right now than anything. The first day of September - the market shows some weakness and then it just kind of starts to feed on itself," he said. "Everybody is kind of looking over their shoulder."
Deming referred to the fact that many investors had some fear of what might happen in September, which historically has been the worst month for stocks. Many analysts said the change in calendar was one of many factors that created a critical mass of sorts for the market and fueled Tuesday's drop.
Banks and insurance companies were among the most notable losers amid the fears of bank failures, but they also had been pumped up the most in the rally that lifted the market more than 50 percent since hitting 12-year lows in March.
With the government reporting last week that 400 banks were in trouble during the second quarter, investors' anxiety about the health of the financial industry was heightened and so rumors that investors might shrug off in less fractious times became powerful enough to cause sustained losses.
The plunge in stocks came even as the Institute for Supply Management reported that U.S. manufacturing grew in August for the first time since January 2008. The market also shrugged off another positive economic report, the sixth straight monthly increase in pending home sales.
On the surface, the day's economic numbers were good. A deeper look at the data gave some cause for concern.
Analysts said both the manufacturing and housing reports got a boost from government stimulus efforts, including the Cash for Clunkers program that has since expired, which means the recovery in those industries may not continue at the same pace.
"In both cases it seems headlines overstate details by a touch," said Tom di Galoma, head of U.S. rates trading at Guggenheim Capital Markets LLC. "People reviewed the numbers and said this type of demand is just not sustainable."
Investors were also uneasy ahead of Friday's employment report from the government, which could reveal more bad news about the job market, one of the worst remaining problem areas in the U.S. economy.
The Dow dropped 185.68, or 2 percent, to 9,310.60. The index is down 270 points, or 2.8 percent, since Friday, its biggest drop over three days since July 7, when it lost 341 points.
The S&P 500 fell 22.58, or 2.2 percent, to 998.04, while the Nasdaq composite index fell 40.17, or 2 percent, to 1,968.89.
The day's retreat was broad:
- Of the 30 stocks that make up the Dow industrials, only Wal-Mart Stores Inc. rose.
- Five stocks fell for every one that rose on the New York Stock Exchange, where volume came to 1.6 billion shares compared with a light 1.4 billion Monday.
- The Chicago Board Options Exchange's Volatility Index, known as the market's fear index, surged 12.1 percent, its biggest jump since Aug. 17. The VIX stands at 29.2 and is down 27 percent in 2009 and its historical average is 18-20. It hit a record 89.5 in October at the height of the financial crisis.
In other trading, the Russell 2000 index of smaller companies fell 14.01, or 2.5 percent, to 558.06.
Bond prices turned mostly higher after stocks began to fall and investors went in search of safer assets. The yield on the benchmark 10-year Treasury note, which moves opposite its price, fell to 3.38 percent from 3.40 percent late Monday.
While the pullback in stocks Tuesday was significant, even with the drop, stocks have risen so much that only one of the roughly 3,100 stocks traded on the NYSE hit a new annual low. And, 53 carved new highs.