NEW YORK (MarketWatch) -- Stocks plunged Tuesday, with the Dow industrials tumbling to their biggest drop in nearly a year, after a key service sector gauge contracted in January possibly signaling that the U.S. economy is already in recession.

The Dow Jones Industrial Average DJIA, -0.47% tumbled 370 points, or 2.9%, to 12,265, with all of its 30 component stocks in negative territory. It was the worst percentage decline for the Dow since February 2007, when the index fell 3.3%. It was also its worst point drop since August.

"The ISM index fell off a cliff," said Peter Cardillo, chief market economist at Avalon Partners. "It's one more piece of bad news on the economy, adding to the credit woes, the downgrades, and the political arena heating up."

The Institute for Supply Management (ISM) said its nonmanufacturing index fell to 41.9% in January from 54.4% in December, well below the 53.0% expected by economists. Readings below 50% indicate most firms are contracting. See full story.

The 'R' word

In a speech Tuesday, Richmond Federal Reverse President Jeffrey Lacker became the first Fed official to say publicly that the economy faces the risk of a recession.

The ISM report came on the heels of a drop in employment in January and a much weaker-than-expected estimate of fourth-quarter economic growth.

"(The ISM data) raised additional concerns that the slow-down which was being partially supported by the service sector is quickly sliding into a full blown recession," said Robert Pavlik, chief investment officer at Oaktree Asset Management.

"Adding to the selling pressure are money managers who are scared that they might have gotten into some of the financials and retailers over the past two weeks a bit too early and they're moving back to cash," Pavlik said in a note.

Stocks had rallied over the past two weeks as the Federal Reserve aggressively cut interest rates down to 3% to help stave off a recession and ease an ongoing credit crisis in financial markets.

But after rallying 6.5% in the past 10 days of January, the broad S&P 500 Index SPX, -0.48% fell on Monday, and slid another 3.2%, or 44 points, to 1,336 on Tuesday.

The S&P 500, which is heavily influenced by financial stocks, is down 8.9% for the year so far, the worst year-to-date decline ever in the history of the index, topping a 7.95% drop in 1939, according to Standard & Poor's.

The tech-heavy Nasdaq Composite Index COMP, -0.29% fell 73 points to 2,309.

Trading volumes showed 1.6 billion shares exchanging hands on the New York Stock Exchange, with declining issues topping gainers by a ratio of 4 to 1. On the Nasdaq, 2.5 billion shares traded, with decliners topping gainers by nearly 4 to 1.

Financial woes

Among Dow components, insurance giant AIG AIG, -1.23% along with financials stocks American Express AXP, -1.08% , Citigroup Inc. C, -2.12% and J.P. Morgan Chase JPM, -0.84% , fell the most.

The outlook for stocks of many financial firms remains clouded by uncertainty over charges linked to bad home loans. At the same time, the insurers of bonds tied to those loans are also coming under heavy pressure, threatening to worsen an ongoing credit crisis in global financial markets.

Wall Street firms and regulators are said to be working on a plan to bail out these insurers.

"The real problem is not just the sour economic problems but the bond insurers -- and not knowing whether that rescue plan is going to come into place," said Avalon's Cardillo.

Meanwhile, shares of bond insurers Ambac Inc. ABK, and MBIA Inc. MBI, -4.41% were on the rise Tuesday.

Downbeat Yahoo

Among technology shares, Yahoo YHOO fell 1.2% after Banc of America Securities analysts downgraded prospective Yahoo buyer Microsoft MSFT, -1.04% to neutral from buy.

"Even if Yahoo shareholders approve a deal with Microsoft, we believe the acquisition could face significant regulatory hurdles in the U.S. and particularly in the EU, which could delay the acquisition from closing for quite some time," the analysts said.

Also hitting tech shares, National Semiconductor NSM, -3.29% fell 7% after warning of lower quarterly sales.

Other markets

Following the ISM data, market odds that the Federal Reserve will cut interest rates by another 50 basis points at its next meeting jumped to 100%, according to Action Economics.

Treasury bonds rallied -- as they often do when inflation pressures abate and when the odds of a rate cut increase -- with the benchmark 10-year Treasury bond up 25/32 at 105 22/32, yielding 3.556%. See full story.

The U.S. dollar still put in sizeable gains Tuesday against the euro and the yen, as a rate hike from Australia put pressure on the low-yielding Japanese currency and data out of Europe was on the weak side.

With the dollar on the ascent, gold futures for April delivery fell more than $19 to end below $900 an ounce. See full story. Crude-oil futures fell $1.61, or 1.8%, to $88.41. See full story.

On the move

There were a number of earnings reports, including conglomerate Tyco International TYC, and corn refiner Corn Products International CPO topping analyst earnings estimates.

NYSE Euronext NYX reported a 39% rise in adjusted profit, and Toyota Motor TM, -1.29% said its profit rose 7.5% in the last quarter.

News Corp. NWS, -3.57% Chairman and CEO Rupert Murdoch said separately his company won't bid for Yahoo. News Corp. owns MarketWatch, the publisher of this report.

Overseas, the Nikkei 225 fell 0.8% in Tokyo but the FTSE 100 fell 2.6% after the U.S. data.