U.S. stocks fell for a third straight day on Tuesday, spooked by uncertainty over the health of financials and concerns that the explosive rally since March may have run ahead of economic reality.

September began living up to its reputation as the worst month for stocks as elevated anxiety pushed the three major indexes down 2 percent for the day, their worst percentage losses since Aug 17.

Skepticism that stocks can add to a nearly 50 percent rally over the last six months prevailed in the market, sending the S&P 500 below the psychologically important threshold of 1,000.

"The wall of worry that the market is trying to climb has gotten higher" into September, said Michael James, senior trader at Wedbush Morgan in Los Angeles.

"People started selling into good macro news since a few days ago, and that was accelerated today by a couple banks today," he said, adding that growing anxiety was creating major weakness in the market.

The KBW bank index dropped 5.8 percent. Among the top drags were shares of JPMorgan Chase & Co , down 4.1 percent at $41.67, and Citigroup , down 9.2 percent at $4.54.

After a brief period of optimism in early trading, investors largely played down the first sign of growth in manufacturing in a year and a half, and the highest level of pending home sales since June 2007.

The Dow Jones industrial average tumbled 185.68 points, or 1.96 percent, to close at 9,310.60. The Standard & Poor's 500 Index fell 22.58 points, or 2.21 percent, to 998.04. The Nasdaq Composite Index lid 40.17 points, or 2.00 percent, to 1,968.89.

Fears of a revival of balance-sheet troubles in the financial sector led to a sharp rise in the CBOE Volatility Index (Chicago Options:^VIX - News) or VIX. Known as Wall Street's favorite barometer of investor fear, the VIX shot up 12.1 percent to 29.15, the highest level since early July, as investors used options to take out protection against further declines in stocks.

Solid evidence that the economy was pulling out of the worst recession in 70 years came from the Institute for Supply Management's August manufacturing index, which grew for the first time in 19 months, partially driven by the government's cash-for-clunkers program.

The same scheme saw U.S. auto sales booming in August, but U.S. stocks ignored the sales data, sending Ford Motor Co down 4.7 percent to $7.24 despite a 17 percent rise in its monthly sales.

Shares of Internet auction house eBay Inc dropped 2.1 percent to $21.68 after the company announced its plan to sell a majority stake in its online phone unit Skype for $1.9 billion to private investors.

Volume was heavy -- unusual for the last week of August -- on the New York Stock Exchange, where 1.63 billion shares changed hands, above last year's estimated daily average of 1.49 billion.

On the Nasdaq, about 2.76 billion shares traded, above last year's daily average of 2.28 billion.

Declining stocks outnumbered advancing ones on the NYSE by a ratio of 5 to 1. On the Nasdaq, about seven stocks fell for every two that rose.