"The 25-basis-point cut was more than priced into the market. Many traders were expecting a 50-basis-point cut and when that did not occur, the disappointment was met with heavy selling in stocks," said Tim Biggam, lead option strategist at online brokerage thinkorswim, in Chicago.
"In addition, the Fed's outlook did not present a slam dunk case for a further rate cut, which led many traders to trim their long positions in stocks."
Other markets were reacting to the Fed as well.
Oilrose above $90 on hopes that the Fed's move would be enough to spur the economy and avoid a downturn in demand, while the dollarhit a one-month high versus the yen and Treasuryssurged as traders repositioned themselves following the Fed ruling.
Large manufacturers and banks, both beneficiaries of lower interest rates, dropped sharply after the decision.
Boeing and American Express led the Dow lower, while Bank of America and Citigroup were among the top drags on the S&P 500. Housing stocks also slumped badly.
General Electric shares were down after the Dow leader's reaffirmed earnings guidance was below analyst estimates. All but two of the Dow components were in negative territory following the Fed.
Throughout the day, the ever-present specter of the subprime collapse hovered over the market.
Washington Mutual said after the bell Monday that it would slash its dividend, cut more than 3,000 jobs, and announced a $2.5 billion capital infusion as it was hit by the subprime crisis. Analysts doubted whether the capital would be enough to see the bank through the next few quarters.
UBS gave back gains, a day after the Swiss bank reported a $10 billion subprime writedown, though it said it wouldn't need any additional capital infusions beyond the one it reported yesterday.
In other news impacting the market, top U.S. phone company AT&T said it would raise its quarterly dividendto 40 cents a share from 35.5 cents and would buy back 400 million shares under a new repurchase program. Shares gained more than 3.5 percent in premarket trading.
Other Market Movers
In closely watched earnings news, Kroger, the largest US grocery chain, posted an 18 percent increase in quarterly profit Tuesday on solid sales growth and a tax benefit, though its gross margin slipped and the stock showed weakness, even though results beat expectations.
Pharmaceutical Medarex continued its slide, a day after disappointing test results for a blood cancer drug it had been marketing.
In acquisition news, French-Italian semiconductor STMicroelectronics said it is buying loss-making Genesis Microchip in a cash deal valuing the US video chip provider's equity at $336 million. Genesis shares jumped more than 57 percent.
-- Reuters contributed to this report.