Stocks tumbled 2 percent on Tuesday after a surprise proposal that Greeks should vote on a EU bailout plan threatened to upend weeks of painstaking negotiations and unleash the region's sovereign debt crisis with renewed force.
Analysts said if Greek voters reject the unpopular bailout in a referendum proposed by Greek Premier George Papandreou, it would result in a hard default by Greece, causing bigger losses for banks and raising the threat of systemic risk.
The speedy pullback in U.S. equities this week comes after stocks rebounded to post their best month in 20 years in October. The reversal has cast doubt on the sustainability of the rally after last week's European Union summit.
The fact that we gave it back as quick as we did in two days is very concerning, said Ari Wald, an analyst at Brown Brothers Harriman. It looks very much as though it was a lot of short-covering, a lot of bears found themselves on the wrong side of the trade.
The S&P 500 has slid 4 percent so far this week in moves reminiscent of the stomach-churning market swings seen over the past two months.
News of the referendum slammed European stocks, particularly the region's banks, which slumped 9 percent. U.S. banks were also hit hard. Morgan Stanley, which investors worry has hefty exposure to Europe, fell 5.5 percent to $16.75.
Indexes swung sharply as successive European lawmakers lined up behind the bailout package, cutting losses in the afternoon after ruling party lawmakers demanded Papandreou resign for throwing Greece's euro membership into jeopardy.
The Dow Jones industrial average dropped 182.32 points, or 1.53 percent, to 11,772.69. The Standard & Poor's 500 Index dropped 22.05 points, or 1.76 percent, to 1,231.25. The Nasdaq Composite Index dropped 52.28 points, or 1.95 percent, to 2,632.13.
This vote in Greece is going to hang over the market for next week or so, unfortunately, said John Canally investment strategist and economist for LPL Financial in Boston.
Adding to the gloomy sentiment, factory activity in Asia's big export economies slowed to their weakest rate in nearly three years in October, while UK manufacturing suffered a sharp decline, reigniting fears of a global slowdown.
The S&P 500 traded below its 14-day moving average for the first time since October 7, pointing to a possible shift in short-term momentum. The benchmark also broke through support at 1,220 several times.
Wald said the S&P 500's 50-day moving average was now key support of the downside.
You have got to cut it short at that 50-day moving average, he said. If we can't hold the 50-day, which is around 1,190, it wouldn't be a very good technical picture.
Economic data showed the pace of growth in the U.S. manufacturing sector slowed in October, though improvement in new orders suggested resiliency in the sector.
If we can keep Europe out of the headlines and Washington out of the headlines and just focus on the economic data and the corporate data we'd be in great shape, said Canally.
In a move that put further pressure on commodity prices, Japan vowed to step into foreign exchange markets again. The government sold a record $98.7 billion on Monday in yen to curb its strength, which is hurting Japan's export-based economy.
The U.S. dollar index rose 1.2 percent. U.S. oil futures dropped 1.4 percent, and copper prices fell 3 percent. Many commodities are priced in the greenback, making a spike in dollar prices more expensive for traders in other currencies and saps demand.
(Editing by Kenneth Barry)