NEW YORK - Wall Street plunged Tuesday, driving the Dow Jones industrials down 370 points after investors saw an unexpected contraction in the service sector as evidence the economy is sinking into recession. It was the Dow's biggest percentage drop in almost a year.
The volatility that pummeled stocks in January returned with the news that the service sector shrank last month for the first time since March 2003. The report from the Institute for Supply Management wiped out the nascent optimism about the economy that had sent stocks surging higher last week.
"The report drives a nail into the coffin from investors' minds that we're in a recession," said Todd Salamone, director of trading at Schaeffer's Investment Research. "That doesn't mean stock prices in the months ahead will be lower. But when you see headline numbers like this, there tends to be a reactionary sell."
The ISM said its index of service sector activity, which accounts for about two-thirds of the economy, dropped below 50, a level that indicates contraction. The market had expected another month of growth, and the disappointment contributed to Tuesday's $500 billion loss in the Dow Jones Wilshire 5000 Composite Index, an index that measures the movement in 5,000 U.S. stocks.
Alongside the Labor Department's report last week showing the first monthly U.S. jobs decline in more than four years, the data on the service sector — which includes businesses ranging from restaurants to retailers to banks — was particularly worrisome to investors.
Though Wall Street hopes the Federal Reserve will keep slashing interest rates to stoke the economy, some believe the central bank, which lowered rates 1.25 percent in just over a week last month, acted too late. Rate cuts take several months to take effect, and moreover, many analysts are skeptical that rate cuts are the correct remedy for an economy saddled with bad debt in the wake of a housing market implosion.
Fitch Ratings' plans to lower the rating on more than $100 billion wrapped up in bond funds called collateralized debt obligations added to the host of concerns plaguing Wall Street. Downgrades would mean the securities — many of which are backed by mortgages — are worth even less than many investors thought. That could cause more problems for strugging banks, brokerages, and bond insurers hurt by investments in mortgages that went sour.
The Dow fell 370.03, or 2.93 percent, to 12,265.13, after falling 108 points on Monday. Tuesday's slide was the blue chip index's largest one-day percentage drop since it lost 3.3 percent on Feb. 27, 2007, and its largest point drop since it fell 387 points last Aug. 9.
The broader Standard & Poor's 500 index lost 44.18, or 3.20 percent, closing at 1,336.64, while the Nasdaq composite index tumbled 73.28, or 3.08 percent, to 2,309.57.
In Monday and Tuesday's trading, the Dow gave up most of the gains it made last week, when it jumped 536 points, or 4.39 percent, in a burst of optimism about the economy. It's not surprising that the volatile market would pull back on any bad economic news — but some analysts claim stocks should be near their bottom given how low investors sentiment is right now.
According to JPMorgan equities analyst Thomas J. Lee, the three worst readings on record in the ISM's service sector index are associated with stocks rising in the ensuing three months — on average, by 6 percent.
Even if the stock market is near its low point, though, it has a lot of ground to recover. The Dow is down more than 13 percent since its Oct. 9 record settlement of 14,164.53. Meanwhile, the S&P 500 — the measure most watched by market professionals — is down 8.9 percent for the year, the worst year-to-date performance for the index ever. The S&P 500 has fallen 14.6 percent from its Oct. 9 high.
Bond prices jumped as investors sought the safety of government-backed debt. The yield on the benchmark 10-year Treasury note, which moves opposite its price, sank to 3.56 percent from 3.64 percent late Monday.
The ISM report is particularly alarming, said Bernard Baumohl, managing director of the Economic Outlook Group LLC. Because Americans will not pare back spending significantly on necessary services like health care and transportation, January's rapid decline in service sector activity suggests that investors may have underestimated how damaged the economy is, he wrote in a research note.
On Tuesday, the biggest losers in the stock market were banks, which have already suffered huge losses in their investment portfolios last year and are now socking billions of dollars away to prepare for debt-burdened consumers to stop making payments.
Dow component Citigroup Inc. fell $2.17, or 7.4 percent, to $27.05, while JPMorgan Chase & Co., another Dow component, fell $2.33, or 5 percent, to $44.28. Washington Mutual Inc. fell $1.08, or 5.6 percent, to $18.08; Bank of America Corp. fell $1.66, or 3.8 percent, to $42.37; and Wachovia Corp. fell $1.35, or 3.8 percent, to $34.18.
"When you have the financials in intensive care such as they are, for any economy like ours, they must heal," said Quincy Krosby, chief investment strategist at the Hartford. "They drew us into this; they must lead us out."
Light, sweet crude oil declined $1.61 to $88.41 a barrel on the New York Mercantile Exchange, as traders bet that a slower economy would dampen energy demand. An extended drop in energy prices could aid businesses that are finding their supply costs are rising, but that their customers are having trouble taking on price increases.
The dollar rose against other major currencies, while gold prices fell.
Declining issues outnumbers advancers by about 4 to 1 on the New York Stock Exchange. Consolidated volume came to 4.18 billion shares, down from 4.51 billion on Monday.
The Russell 2000 index of smaller companies fell 21.88, or 3.02 percent, to 701.58.
Stocks overseas also retreated. Japan's Nikkei stock average fell 0.82 percent; Hong Kong's Hang Seng index fell 0.89 percent; Britain's FTSE 100 fell 2.63 percent; Germany's DAX index fell 3.36 percent; and France's CAC-40 fell 3.96 percent.
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