Stocks ended with significant declines following several disappointing earnings reports and fresh concerns about weakness in the housing industry.
"The housing story has gone from bad to worse. It's pretty clear that the subprime market is not as well contained as a lot of people had been thinking," said David Rosenberg, North American economist at Merrill Lynch. "I thought yesterday was almost a microcosm, you had a 90-point runup in the Dow on the same day the financials were actually negative."
"A lot of the earnings weren't great today and the market took the lead early and sold off and the market couldn't recover," said Todd Leone, head of listed trading at Cowen & Co. "You had Countrywide Financial's report that was very ugly, and Apple was also negative. They are taking some of those stocks and beating them up."
The Dow Jones Industrial Average fell 226 points, or 1.6%, the biggest one-day decline since March 13 and second worst fall of the year. The S&P 500 lost 2.0% and the Nasdaq Composite declined 1.9%.
The closely-watched Russell 2000 index of small cap stocks ended down 2.8% while the Dow Jones Transportation Average fell 1.9%. Trading breadth was overwhelmingly negative with decliners outpacing gainers by a 7-to-1 margin on the New York Stock Exchange.
The sharp afternoon selloff triggered trading curbs on the NYSE prohibiting certain types of computerized index arbitrage trading for the rest of Tuesday's session. The last time downside curbs went into effect was on March 13.
The influential financial sector was one of the worst performing groups, closing with a decline of 2.9%.
Countrywide Financial shares closed down sharply after the country's largest mortgage lender posted a decline in quarterly earnings and cut full-year guidance.
"The financials are dragging the market down, it's kind of a tough environment for the bulls and the weakness may continue," said Tom Schrader, managing director of US listed trading at Stifel Nicolaus.
"The real roots of this problem is that we had 1% interest rates -- extremely low interest rates for awhile, and now rates are back up to normal and some people are being taken out with the wash," said Brian Wesbury, chief economist at First Trust Advisors. "When the tide goes out you can tell who is swimming naked."
Credit-card issuer American Express said late Monday quarterly results were impacted by write-downs for bad loans. Shares of the Dow component declined more than 3% amid heavy trading volume.
The rate-sensitive utility sector fell 3.5% while energy stocks ended down 3.0%. Telecom stocks held up relatively well in a down day, closing down just 0.6%.
Apple fell 3% as investors were disappointed with initial iPhone activations. AT&T reports 146,000 activations during its first weekend on sale. Piper Jaffray analyst Gene Munster, who forecasted weekend unit sales of 500,000, told CNBC's Jim Goldman the initial results were a "disappointment."
AT&T, the network carrier for Apple's new phone, posted a stronger-than-expected rise in quarterly profits. Shares of the Dow component traded flat.
Fast-food company McDonald's posted an in-line profit from continuing operations, but saw a loss on a net basis.
DuPont, the second largest U.S. chemical company and Dow component, missed analysts' expectations with a marginal slip in second-quarter profit to $972 million. The company attributed the shortfall to higher energy costs and lower U.S. sales.
Texas Instruments fell more than 3% after reporting late Monday lower quarterly profits in addition to a disappointing revenue forecast for the third quarter.
Elsewhere, Eli Lilly said this morning that second-quarter earnings fell as acquisition charges hurt the company's performance, but raised its 2007 earnings forecast.
New York light sweet crude futures continued a recent slide, falling below $74 a barrel.
In the currency markets, the dollar fell further against the yen and euro on continued concerns over the strength of the U.S. economy.
Treasury prices ticked higher, sending yields down slightly.
European Stocks Lower
A mix of encouraging and disappointing earnings left European indexes struggling for direction Tuesday, following tentative sessions in Asia and the U.S.
The London FTSE-100, Paris CAC-40 and Frankfurt DAX all traded slightly lower.
Output falls at British energy giant BP saw the FTSE-100 listed company post a 1% fall in second-quarter profit to $6.087 billion. Shares of BP rose 0.7%, however, as the results met expectations.
And shares of BHP Billiton the world's largest mining company, were flat, despite the company reporting strong annual output for materials such as natural gas, copper and nickel, due to a boom in the price of raw materials and high demand from emerging markets.
Elsewhere, Vodafone CEO Arun Sarin is expected to overcome activist shareholders calling for the spinoff of its $50 billion holding in Verizon Wireless at an annual general meeting in London.
Asia Mostly Higher
Tokyo's Nikkei 225 Average edged up to finish higher as strong earnings helped KDDI to rebound, while investors chased after laggards such as Mizuho Financial Group and other bank shares.
Hitachi jumped over 4% on a news report about a new boiler for coal-burning plants which halves nitrogen oxide emissions and cuts costs by as much as 20%.
In South Korea, the KOSPI climbed above the 2,000 level for the first time as financials gained, but then reversed themselves to end flat, as technology stocks like Samsung fell following the weak revenue guidance from Texas Instruments.
Chinese shares were flat despite gains in the steel sector, while Hong Kong blue chips were on the advance, boosted by Wall Street gains, as mainland insurers shot to record highs after Ping An Insurance gave an upbeat profit guidance. Angang Steel and Maanshan Iron & Steel rallied in heavy trade on the back of broker upgrades.