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Markets now fear US economy chilled by more than weather

Traders work on the floor of the New York Stock Exchange.
Jin Lee | Bloomberg | Getty Images
Traders work on the floor of the New York Stock Exchange.

Weak U.S. manufacturing data, on top of more news of slowing activity in China, sent stocks into a tailspin and signaled to some traders that the correction could be deeper than they expected.

The big slide—taking the S&P 500 2.3 percent lower—came amid fireworks in other markets. The Nikkei fell nearly 2 percent, sending the index into a correction of over 10 percent since the beginning of the year. The dollar weakened, the yen rose and emerging markets continued to flounder. The VIX, the CBOE's volatility index, shot up nearly 15 percent to over 21.

(Read more: Stocks unravel after factory report)

The Institute for Supply Management manufacturing index showed Monday that activity had fallen to an eight-month low of 51.3 in January, well below the 56.5 in December. New orders plunged to 51.2, a drop of 13.2 percentage points from December. The index still shows expansion because it is above 50, but it is far weaker than expected and raised red flags that U.S. growth may be slower than thought.

(Read more: Stocks down in January...if history repeats!)

"We're seeing other confirming reports that the economy is not delivering in the zone we were expecting," said Jack Ablin, chief investment officer of BMO Private Bank. "I'm sure I was part of the consensus thinking interest rates were going to rise and bonds were not going to be a good place to be, and the economy wasn't only expanding but accelerating."

Ablin said he thought valuations were too high and that he is looking for a pullback to put more money to work.

"I think we could get a correction of 10 percent or more," he said.

The poor ISM injects even more anxiety into the market ahead of the January employment report Friday, which is expected to show 185,000 new nonfarm payrolls. That number is a key metric watched by the Fed. Last month's weak 74,000 was blamed on weather but raised concerns about growth. The weak number also follows a slowdown in China's manufacturing sector. The official PMI dipped to 50.5 last month from 51 in December, while private sector numbers showed contraction.

"We now have some additional fundamental confirmation of the fact that the [U.S.] recovery is not going in a straight line," said Ian Lyngen,senior Treasury strategist at CRT Capital. Factory orders at 10 a.m. is the only data expected Tuesday.

(Read more: Good intentions pave way to mayhem)

The S&P 500 was off 3.6 percent for January, and its decline Tuesday gives it a 5.8 percent loss for 2014. The decline was spurred partly by a selloff in emerging markets, which have been reacting to concerns about slowing global growth at the same time the Fed is tapering its bond- buying program.

"People were hoping to get 5 percent on the downside," said Patrick Boyle, a trader with BTIG. Traders were looking to buy into that type of drop, but investors may be looking for further declines since it happened so fast, he said.

"It's not the end of the world, Boyle said. "People just didn't think we 'd see it until March or April."

The S&P's decline is its worst since the fall, when it fell 6.3 percent into October, but the market has not had a real correction—10 percent or more—since its 17 percent decline in 2011. The S&P sold off 9.8 percent in 2012.

"The number was much weaker than expected, and the market is very sensitive at this point to thinking that the Fed has started the policy normalization process too soon," said Barry Knapp, head of equity portfolio strategy at Barclays.

As stocks sold off Monday, bonds saw a rush of buying, which pushed the 10-year yield below 2.6 percent for the first time since early November.

"We priced out 46 basis points of tapering, and nobody's changed their mind on tapering," Lyngen said. "No one is saying they're going to increase bond purchases, go the other direction. So it's purely a positioning-and-flight-to-quality move."

The Fed has pared $20 billion from its bond buying and is now purchasing $65 billion a month in Treasurys and mortgages—a program expected to wrap up by year-end.

The big market move comes on the day Janet Yellen was sworn in as Fed chairman.

"The market is testing the new chairman," said Boyle.

Knapp said at times when the Fed is pulling back from easing, the market typically overreacts to any negative news that would suggest the policy is going the wrong way.

"As we know, the Fed's specialty is not taking the punch bowl away too soon," he said.

The market usually gives back about 8 percent during a Fed policy reversal, Knapp said, and the S&P could go down to 1,700 during the process.

(Read more: Cashin—why stocks are getting slammed)

While the U.S. economy was the focus of Monday's selling, economists have been looking for effects of bad weather in all January data. The weak ISM number was blamed on weather, as were weaker-than-expected auto sales.

"It's not a great season for automobile purchases," said Ablin. "Who wants to test drive a car when it's minus 10 and there's a bunch of snow on the ground. ... Seasonal adjustment is one thing, but this is extraordinary. You can't adjust for this kind of thing. Last year at this time, we had a couple of days in the 60s."

Earnings are expected Tuesday from BP, Toyota, Archer Daniels Midland, UBS, Gannett, Becton Dickinson, HCA, Emerson, Eaton, Clorox, Michael Kors, McGraw-Hill Financial, Delphi Automotive, Sirius XM, Fidelity National and Boston Scientific ahead of the opening bell.

—By CNBC's Patti Domm. Follow her on Twitter @pattidomm.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.