By Walter Brandimarte
Shares of financial companies were the biggest drag on the Dow and the S&P 500, with Bank of America <BAK.N> and Wells Fargo <WFC.N> sliding about 4 percent each and the KBW index of bank stocks falling 4.1 percent.
Reminding investors that the effects of the housing slump are still far from over, JPMorgan Securities forecast investment bank Lehman Brothers <LEH.N> will take a further $4 billion of write-downs in the third quarter due to losses from mortgage-related investments.
Goldman Sachs added to the gloomy outlook as it downgraded the price target for the stock of American International Group Inc <AIG.N>, saying the potential for capital raisings and rating downgrades is increasingly likely for the world's largest insurer.
"We are back to struggling again, in the financial sector particularly," said William Stone, chief investment strategist at PNC Financial in Philadelphia. "Underneath some of that is just concern about the overall global economic slowdown."
The Dow Jones industrial average <.DJI> fell 130.35 points, or 1.14 percent, to 11,349.04, while the Standard & Poor's 500 Index <.SPX> declined 12.01 points, or 0.94 percent, to 1,266.59, after earlier falling more than 1 percent to a session low at 1,263.53. The Nasdaq Composite Index <.IXIC> shed 29.30 points, or 1.21 percent, to 2,387.68.
A much higher-than-expected inflation reading for July also scared some investors who fear the U.S. Federal Reserve might be in an increasingly difficult position to maintain its policy of low interest rates.
The government's Producer Price Index shot up at the fastest annual rate in 27 years in July, while core producer prices, excluding volatile food and energy prices, underwent their fastest rise since November 2006.
"Clearly, there is more resilience in the prices than we thought and I think this is reflecting a pass-through from the strength we had seen in commodity prices," said Anna Piretti, senior economist with BNP Paribas in New York.
She said, however, that the weakness in domestic demand should contain prices going forward.
"Consumers are not likely to make very large ticket purchases when prospects in the labor market are weakening and confidence remains very low."
FINANCIALS TUMBLE AGAIN
Shares of AIG plunged 7.3 percent to $20.02 after Goldman Sachs cut its price target on the stock to $23 from $30, while Lehman Brothers lost 9.9 percent to $13.55 on negative forecast by JP Morgan Securities.
Bank of America's shares fell 4.3 percent to $28.02 and Wells Fargo shed 3.9 percent to $27.68.
Shares of home builders also slid following a bleak report on housing starts by the Commerce Department. For the month of July, housing starts dropped 11 percent -- the lowest annual rate in more than 17 years.
Shares of Pulte Homes <PHM.N> , the No. 3 U.S. home builder, declined 2.5 percent to $12.22. The Dow Jones index of home builders' shares dropped 2.6 percent.
On Nasdaq, shares of Staples Inc <SPLS.O> tumbled 4.8 percent to $23.39 after the leading U.S. office supply chain said tough market conditions hurt quarterly results.
(Additional reporting by Ellis Mnyandu; Editing by Jan Paschal)