Uncertainty about a multibillion dollar rescue plan for US automakers also dampened sentiment, analysts said.
The Dow Jones Industrial Average sank 242.85 points to close at 8691.33.
The Nasdaq dropped 24.40 points to 1547.34 and the broad Standard & Poor's 500 lost 2.31 per cent to 888.67.
Analysts said the mood soured after earnings warnings from Texas Instruments and FedEx, among others, and uncertainty over a rescue package for beleaguered US automakers, which was still being examined by the White House.
White House spokeswoman Dana Perino told reporters the auto talks were "still working through a number of issues, some of them just small and technical, and other ones a little bit more meaty in scope" before agreeing to the $US15 billion ($22.85 billion) rescue.
Investors also used the opportunity to lock in some gains.
"We've had a nice run during the last couple of days," said Sam Stovall, equity analyst at Standard & Poor's, referring to rallies Friday and Monday.
"Some investors were thinking it wouldn't hurt to take some profits at this point."
The bond market saw new precedents set as investors flocked to safety.
The yield on the three-month US Treasury bill Tuesday fell below zero for the first time as worried investors snapped up government bonds in search of shelter.
"Investors are desperate to cover short-term and end-of-year funding needs, making them willing to accept negligible - and now even negative - returns to protect their capital," said Sara Kline at Economy.com.
The rest of the bond market also rallied.
The 10-year US Treasury bond yield slipped to 2.669 per cent from 2.734 per cent on Monday and that on the 30 year bond dropped to 3.075 per cent from 3.152 per cent.
Among key stocks FedEx, the delivery giant which lowered its outlook for fiscal 2009 citing weak economic conditions, slid 14.48 per cent to $63.65.
Danaher, a manufacturer of professional tools and medical technologies, the latest key US company to lower its earnings outlook and announce a round of layoffs fell 4.2 per cent to 49.78.
Dallas-based semiconductor maker Texas Instruments which slashed fourth-quarter earnings and revenue forecasts and announced cost-cutting measures, ended with a gain of 4.93 per cent at $15.55.
Among the automakers GM fell 4.67 per cent to $4.70 and Ford lost 4.44 per cent to $3.23 while awaiting deliberations among lawmakers and the White House on the rescue plan.
Analysts at the ratings firm Fitch said the outlook for the industry is bleak whatever the government does.
"Although it appears that temporary government aid will be forthcoming for the Detroit Three, there remains much uncertainty regarding the amount structure, timing and other terms of this assistance," the firm said.
"Fitch has previously stated its view that if General Motors were to file for bankruptcy, industry revenue pressures resulting from the immediate GM price discounting that would occur, as well as the resulting cost and supply issues associated with turmoil in the supplier base, would force Ford to follow at some point thereafter."
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