Bernanke's "sobering assessment of the residential real estate morass on top of his hawkish inflation position is quashing market enthusiasm," said Jack Ablin, chief investment officer at Harris Private Bank.
The Dow Jones Industrial Average closed down 80.9 points at 13,595.5, after falling to a low of 13,551. Out of the Dow's 30 components, 27 retreated, led by shares of Dupont , Wal-Mart Stores Inc. , Merck & Co. and Home Depot Inc. .
Investors were also starting to reconsider the market's valuation, after the market's uninterrupted rally since Mid-March and in light of rising bond yields, which offer a risk-free alternative to stocks.
"This is basically a market that's consolidating," said Peter Cardillo, chief market economist at Avalon Partners.
Among blue chips, DuPont fell 2% after Lehman Brothers downgraded the stock to equal weight from overweight, citing valuation and seasonal factors.
General Motors Corp. and Walt Disney Co. both fell as they held analyst presentations.
The S&P 500 index dropped 8.23 points to 1,530.95, while the Nasdaq Composite lost 7.06 points to 2,611.23.
Trading volumes showed 1.512 billion shares exchanging hands on the New York Stock Exchange and 2.210 billion trading on the Nasdaq stock market. Declining stocks topped gainers by 3 to 1 on the NYSE and by 19 to 10 on the Nasdaq.
By sector, natural gas , gold and transportation all fell. Other declining sectors included broker/dealers and pharmaceuticals .
Retail stocks were also under pressure. Helping to dampen sentiment, Bed Bath & Beyond fell 5.4% after the retailer issued its first-ever profit warning as a public company. Goldman Sachs downgraded the stock to neutral from buy.
Since last week, investors have monitored rising bond yields, which challenge the relative attraction of risk-taking in stocks.
Bernanke's remarks, which predicted moderate growth ahead for the U.S. economy, were seen as upbeat, and pressured bond prices, lifting yields further.
The benchmark 10-year Treasury bond finished down 11/32 at 96 10/32 in price, pushing its yield, which moves inversely to price, up to 4.974%, a nine month high. The benchmark yield ventured as high as 4.91% but failed to break through 5%.
In a speech, Bernanke said that while the housing downturn, including the subprime mortgage market, is continuing, he still doesn't expect it to spill over to the rest of the economy. The Fed Chairman also expects moderate growth to continue.
"The good news is the chairman believes the subprime mortgage problem won't leach into the mainstream economy," said Harris Bank's Ablin. "The bad news is that any thoughts of a rate cut are fading as quickly as the Yankees' playoff chances."
Putting further pressure on bonds, the Institute for Supply Management said the service-sector of the U.S. economy grew at a robust pace in May, the Institute for Supply Management reported Tuesday.
The ISM nonmanufacturing index rose to 59.7% from 56% in April. It's the highest since April 2006. Economists surveyed by MarketWatch were looking for a pullback to about 55%.
The dollar was weaker against major currencies, as investors viewed Bernanke's speech and remarks as unlikely that the Fed might hike interest rates. Meanwhile, the European Central Bank is widely expected to hike interest rates on Wednesday.
Crude oil prices fell back as some traders considered the recent rally on weather-related production concerns in the Persian Gulf and tension between Russia and the West to be a bit overdone or now. Crude for July delivery lost 60 cents to close at $65.61 a barrel.
Gold prices fell, tracking crude oil. Gold for August delivery lost $1.20 to close at $675.10 an ounce.
"This market managed to shrug off China yesterday," said Avalon's Cardillo. All the deal-making news, he said, have so far helped investors brush aside concerns about volatility in the Chinese stock market, as well as worries about the U.S. economy and interest rates.
U.S. stocks had ended Monday with a modest rise, overcoming a tumble in Shanghai-listed stocks, rising crude-oil prices. Overnight, the Shanghai Composite lost 7% before recovering and closing on a 2.6% gain.
In new deal developments, Avaya gained 1.8% after agreeing, as rumored, to be bought by TPG Capital and Silver Lake Partners for $8.2 billion, or $17.50 a share in cash.
Amgen rose 1.1% after agreeing to buy privately held Ilypsa for $420 million. For nearly the same amount, Ericsson agreed to buy German billing software firm LHS.
By Nick Godt