Stocks staged a late-day comeback from session lows Tuesday after traders were disappointed by comments from Sarkozy and Merkel, but the gains were not enough for the market to finish in positive territory.
The Dow Jones Industrial Average declined 76.97 points, or 0.67 percent, to close at 11,405.93, led by BofA and Alcoa . The Dow was down 190 points in its session low.
Home Depot and Wal-Mart led the blue-chip gainers.
The S&P 500 slumped 11.73 points, or 0.97 percent, to end at 1,192.76 and the Nasdaq fell 31.75 points, or 1.24 percent, to finish at 2,523.45.
The CBOE Volatility Index, widely considered the best gauge of fear in the market, ended near 33.
Most S&P sectors were lower, led by financials and energy. The banking sector has alternated between gains and losses every day since last Monday.
Stocks hit session lows after French President Nicholas Sarkozy and German Chancellor Angela Merkel agreed to float proposals for a tax on financial transactions and as both leaders indicated that the size of the EFSF (European Financial Stability Facility) is sufficient.
"This tax will not be well received," said Todd Schoenberger, managing director LandColt Trading. "German citizens are going to be taxed to pay for some other nation's profligacy?! Yeah, that's gonna go over real well—Don't be surprised to see European bourses get slammed tomorrow."
Sarkozy and Merkel also said they want a "true European economic government" that would consist of the heads of state, but ruled out issuing Euro bonds to fix the debt crisis, disappointing traders.
Meanwhile, Euro zone growth for the second quarter slowedto 0.2 percent quarter-on-quarter, below forecasts for growth of 0.3 percent and at the slowest pace since 2009. A much weaker than expected GDP figure for Germany in particular weighed on European markets.
European banking stocks were among the hardest hit following the news, dragging U.S. financials such as BofA , Citigroup and Morgan Stanley lower as well.
Meanwhile, Fitch affirmed its AAA statuson the U.S. and said the outlook for the credit rating was "stable." This comes after rival Standard & Poor's downgrade more than a week ago, which rocked global markets.
Gold prices gained to settle at $1,785 an ounce, rebounding from a correctionit began late last week.
On the earnings front, Wal-Mart rose after the big-box retailer beat sales expectations, helped by its international business and Sam's Club franchise. Rival Target was also trading higher and is expected to post earnings Wednesday morning.
Home Depot also gained after the home improvement chain raised its profit forecastfor the second time in three months, as the firm gained market share from rival Lowe's .
Among retailers, TJX slipped even after the clothing chain beat profit expectations. Saks also slid after the department store operator reported a narrower-than-expected quarterly loss and forecast same-store sales growth for the rest of the year, but said it is cautious about falling sales.
Urban Outfitters tumbled after the clothing retailer's profit and margins declined due to deep discounting. In addition, at least three brokerages cut their ratings on the firm.
Dell is scheduled to post earnings after-the-bell.
In the most recent 13-F filing, Warren Buffett's Berkshire Hathaway added a new stake in Dollar General . The firm also increased its position in MasterCard and Wells Fargo , while decreased holdings in Kraft . (More: Berkshire Hathaway's Biggest Holdings)
Volume was light with the consolidated tape of the NYSE at 4.25 billion shares, while 1.13 billion shares changed hands on the floor.
On the economic front, U.S. industrial output gained in July at its fastest pace in seven months, helped by robust auto production.
Also, housing starts fell less than expected in July, according to the Commerce Department. Still, the figure is half the 1.2 million homes per year that economists say must be built to sustain a healthy housing market.
Meanwhile, U.S. import prices increased in July, according to the Department of Labor.
—Follow JeeYeon Park on Twitter: twitter.com/JeeYeonParkCNBC—
Coming Up This Week:
WEDNESDAY: Weekly mortgage apps, PPI, oil inventories; Earnings from Deere and Target
THURSDAY: CPI, jobless claims, existing home sales, Philadelphia Fed survey, leading indicators, money supply, Forest Labs shareholder mtg; Earnings from Sears, Hewlett-Packard and Gap
FRIDAY: Fed's Pianalto speaks, Google IPO anniversary
More From CNBC.com: