U.S. stocks fell on Tuesday after a prominent banking analyst warned the sector's fundamentals have yet to improve, and an unexpectedly large drop in wholesale inventories raised worries about an economic recovery.

Financial stocks, which had gained about 25 percent in the last month, tumbled after Rochdale Securities analyst Richard Bove painted a gloomy outlook for the banking industry. He said bank stocks are trading on fumes, and he expects a short-term pull-back in their stock prices.

The financial sector of the S&P 500 <.GSPF> shed 3.5 percent while the KBW Bank Index <.BKX> was down 4.4 percent. The stocks were also affected by a report late Monday from the Congressional Oversight Panel, which highlighted the risks of toxic assets still on the books of many banks.

Banks aren't out of the woods yet, said Kevin Kruszenski, head of listed trading at KeyBanc Capital Markets in Cleveland.

There are some worries about additional equity that needs to be raised. The market is going to have a hard time moving meaningfully higher without them, Kruszenski said.

The drop in U.S. wholesale inventories in June, which was nearly double expectations, suggests that businesses remained skeptical about a return in demand.

The Dow Jones industrial average <.DJI> closed down 96.28 points, or 1.03 percent, to 9,241.67. The Standard & Poor's 500 Index <.SPX> fell 12.77 points, or 1.27 percent, to 994.33. The technology-laced Nasdaq Composite Index <.IXIC> slid 22.51 points, or 1.13 percent, to 1,969.73.

Adding to losses for financials, Miller Tabak cut its price targets on Zions Bancorp and Regions Financial Corp . Shares of Zions stumbled 8.4 percent to $16.43, while Regions dropped 4.2 percent to $4.76.

The S&P Regional Banks sub-index <.GSPBNKS> slipped 4.2 percent.

The Congressional Oversight Panel, a watchdog for the government's bailout program, said toxic loans and securities continue to pose a threat to the financial system, particularly for smaller banks that face mounting losses on commercial real estate loans.

After the closing bell, Applied Materials Inc shares rose 3.6 percent to $13.70 as the world's largest chip equipment maker reported a sharply narrower quarterly loss on better-than-expected revenue, due to a jump in new orders and deep cost cuts.

Investors were also cautious as a two-day monetary policy meeting by the U.S. Federal Reserve got under way on Tuesday. The focus will be on signs from the Fed of an exit strategy from its quantitative easing policy. Also weighing was a report on July retail sales, due Thursday.

Earnings reports are due this week from retailers Wal-Mart Stores Inc , J.C. Penney Co Inc and Macy's Inc , which may provide some insight on whether consumer spending, which accounts for roughly two-thirds of the U.S. economy, is stabilizing.

Another worrying sign of a still-weak economy came from hedge fund firm Atticus Capital LLC, which told investors that it is closing two of its three funds and would return $3 billion to shareholders.

The negative news overshadowed better-than-expected data on U.S. non-farm productivity in the second quarter, which showed worker productivity rose at its fastest pace in six years as hours worked fell much more steeply than output.

Volume was light on the New York Stock Exchange, with 1.17 billion shares changing hands, below last year's estimated daily average of 1.49 billion, while on the Nasdaq, about 1.91 billion shares traded, below last year's daily average of 2.28 billion.

Declining stocks outnumbered advancing ones on the NYSE by a ratio of 2,226 to 801, and declining stocks beat advancers on the Nasdaq, by about 1,931 to 719.

(Editing by Leslie Adler)