A mix of rumors and growing concerns that more banks will fail pummeled the financial industry, which had posted some of the biggest gains since the stock market began its huge advance in March. Investors saw a batch of economic reports that just weren't good enough as a parallel reason to sell.
All the major indexes fell about 2 percent. The Dow Jones industrials fell 186 points. The Nasdaq lost 40 and the S&P 500 was down 23.
Meanwhile, bond prices edged higher as investors sought the safety of government debt. The price of oil tumbled as the dollar strengthened and amid concerns that the economy isn't strong enough to support higher demand for energy.
Analysts said there were other forces at work in the market, including lingering concerns about the Chinese economy, whose problems would affect the rest of the world. And investors, cognizant of the market's tendency to sag in September, also seized upon that to justify pulling money out of stocks.
Banks and insurance companies were the most notable losers, but they also had been pumped up the most in a rally that lifted the market more than 50 percent since hitting 12-year lows in March.
Traders said rumors were making the rounds in the market. But 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 is heightened.
Anton Schutz, portfolio manager of Burnham Financial Industries Fund and Burnham Financial Services Fund, said talk of a possible major bank failure rattled the market.
"Nothing has been substantiated," he said. "This market is easily spooked after we've had such a run," he said.
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.
Investors have long since factored in an economic recovery into stock prices, but analysts, worried that investors have been too optimistic, have been anticipating a downward turn. Trading has been choppy recently as investors also questioned whether their bets on the economy have been warranted.
"The market's priced all of this in, and a lot more, quite frankly," said Jeff Buetow, managing partner at Innealta Portfolio Advisors. "I just don't see the growth out there."
On the surface, the day's economic numbers were good. But 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 are also hesitant to buy stocks ahead of Friday's employment numbers, which could reveal more bad news about the job market, one of the worst remaining problem areas in the U.S. economy.
Nearly five stocks fell for every one that rose on the New York Stock Exchange, where volume came to 1.1 billion shares compared with a light 675.8 million shares traded at the same time Monday. Volume has been light as some traders break away for vacation before Labor Day. That can leave the market vulnerable to big swings.
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.
Light, sweet crude for October delivery tumbled $1.82 to $68.14 a barrel on the New York Mercantile Exchange, bringing down shares of energy companies with it. Gold prices fell.
Although the market pulled back in recent days, stocks managed to put in their best August since 2000. September, however, is historically the worst month for stocks.
"It's a self-fulfilling prophecy," said Steve Stahler, president of The Stahler Group in Baton Rouge, La., of investors entering the month knowing it's typically weak.
Stahler added that there are no longer indicators on the horizon that can continue to propel the market forward at such a dizzying pace.
"We've had a heck of a run," Stahler said. "When has that type of gain been sustainable? It never has."
The reaction to the day's economic reports signaled that many traders are more concerned about how much stocks have rallied.
The Institute for Supply Management said Tuesday that its index of manufacturing activity rose to 52.9 in August, up from 48.9 in July and well above the reading of 50.5 analysts had been expecting. A reading above 50 signifies growth in the industry - something that hasn't happened since January 2008.
Meanwhile, the National Association of Realtors said its index of pending U.S. home sales rose 3.2 percent in July to 97.6, more than the 96.5 forecast by analysts. It was the reading's highest level in more than two years, helped by a surge of first-time buyers taking advantage of a tax credit that expires this fall.
It was the sixth straight increase and 12 percent above the same month last year.
Overseas, Japan's Nikkei stock average rose 0.4 percent. Britain's FTSE 100 dropped 1.8 percent, while Germany's DAX index tumbled 2.5 percent and France's CAC-40 fell 1.9 percent.
China's Shanghai Composite Index rose 0.6 percent after a 6.7 percent plunge on Monday that sent a wave of selling around the globe.