Stocks closed broadly lower and the Dow saw a triple-digit loss amid mixed signals from the Federal Reserve and weak economic data.
"I think the market is going through a tremendous amount of uncertainties," said John Manley, private client strategist at Smith Barney. "There's a lot of bipolar risks, we could go one way or the other. People are nervous about that ... more than anything specifically fundamental."
The Fed's Beige Book report said that, outside of real estate, turmoil in the financial markets was having a limited impact on the rest of the economy. The comments were viewed as a mixed message as to whether or not the Fed will cut interest rates on Sept. 18.
"The headlines from the Beige Book show that this is so far contained," said David Joy, chief market strategist at RiverSource Investments. "Manufacturing continues to be strong and the consumer, beyond the subprime issue, remains relatively healthy. So my vote is the Fed doesn't cut rates."
The release of the Beige Book came on the heels of initial market weakness due to weak pending home sales and a disappointing ADP employment report.
"The housing number kind of threw people off because, up until now, it was a financial worry," said Arthur Cashin, UBS director of floor operations. "Now we're beginning to see people who have handshakes on houses coming in and saying their mortgage fell through. It looks like it's starting to affect the economy."
The National Association of Realtors said pending home sales fell by 12.2% in July from June, the largest drop since the index started in 2001. Sales of existing homes fell as borrowers struggled to finalize home purchases, particularly in expensive neighborhoods.
"There's no way to sugarcoat these housing numbers -- the data was awful for July, much worse than expected," Mike Larsen, senior real estate analyst for Money and Markets, told CNBC.com. "I think it's likely August will be another rough month with what we've seen in the mortgage market."
Selling was across the board with all of the S&P 500 sectors closing in negative territory.
The influential financials sector was the biggest percentage decliner with a loss of 2% as Citigroup's research unit cut estimates on Lehman Brothers and Morgan Stanley .
Retailers fell sharply on worries about consumer spending after Costco said August same-store sales rose a weaker-than-expected 2%. Declining shares led advancers by about four to one on the New York Stock Exchange.
Traders continued to worry about the rising costs of borrowing. In London, the three-month Libor rate inched up to 6.8%, the highest level since November 1998, reflecting a continuing rise in the cost for banks to borrow money from each other over a three-month period.
Announced layoffs surged 85% in August, according to employment consulting firm Challenger, Gray & Christmas. The independent report showed layoffs skyrocketed as the housing slowdown and subprime mortgage debacle led to record job cuts in the financial sector.
"I think every one of these economic indicators that we get over the next two weeks is going to mean so much," said Stephen Porpora, managing floor broker at William O'Neil. "The employment report on Friday is going to be even more important. That's the mode we're in until the Fed meets on the 18th of September."
Treasury prices extended gains as investors flocked to safety, sending the yield on the 10-year note to a 5-month low.
New York light sweet crude futures closed above $75 a barrel amid supply jitters. Crude oil ended higher for the third straight session and has gained more than 9% in the last nine trading days.
European stocks closed sharply lower, with investors worried about the U.S. consumer and waiting to see what the European Central Bank will do on interest rates on Thursday.
Asian stocks closed mixed, with Japan bearing the brunt of the decline.
Traders were still expecting volatility near term in the markets. The CBOE Volatility Index rose.
"There's absolutely going to be volatility in the near term," said Simeon Hyman, equity strategist at Lehman Brothers Private Investment Management. "We're going to wake up one morning and be happy with what we think the Fed's going to do. Then we're going to wake up the next morning and be unhappy."