The Dow Jones Industrial Average plunged 279.65 points, or 2.22 percent to close at 12,290.14.
The S&P 500 slipped 30.65 points, or 2.28 percent to end at 1,314.55.
The Nasdaq fell 66.11 points, or 2.33 percent to finish at 2,769.19.
The CBOE Volatility Index, widely considered the best gauge of fear in the market, surged 18.45 percent, to end at 18.30.
The Dow and S&P have seen the biggest drops since August 11, 2010 and are now on pace for a fifth straight week of losses. The Nasdaq saw its worst first day of the month since October 2009. All 10 key S&P 500 sectors dropped, led by financials, materials and industrials.
“This is a fairly volatile move the past two days within a range bound market,” McMahon said.
Even though the S&P index broke through the 100-day moving average of 1,317, a level it has held since March, McMahon said the selloff won't mean much unless stocks continue to trade lower, validating the move.
Moody's cut Greece's bond ratings by another notch into junk status. In addition to the increased risk of restructuring, the agency cited "highly uncertain" growth prospects and missed targets in budget reforms.
Financials led the markets lower, with the KBW Bank Index sinking to a six-month low and below its 200-day moving average, following more dismal news on the housing market Tuesday when the S&P/Case-Shiller home price index showed home prices fell to a new recession low in the first quarter.
Banks are exposed to the housing market not only through their loan portfolios, but also through holdings of mortgage-backed securities.
General Motors, Ford and Toyota slipped after the automakers posted figures that showed a decline in May auto sales. In addition, Toyota said it is recalling 105,000 early models of the Prius because of problems with power steering and the gearbox.
Nokia declined for a second day to a 13-year low after at least eight brokerages cut their price target on the stock. The mobile phone handset maker cut its sales outlook Tuesday and said it expects sales from its products and services to be far worse than initial projections. Research In Motion also slipped amid worries the Blackberry maker could be in a similar situation.
Juniper plunged after the CEO said the firm may see a negative impact from the Japanese earthquake and added that the company is not immune to reduced federal spending.
Also on the tech front, Yahoo slumped despite news the search-engine company said it resolved a dispute with partner Alibaba Group over the Chinese company's transfer of its prized online payments unit.
Among retailers, Macy's slipped even after the department-store chain reported a 7.4 percent gain in May sales, beating the 5.6 percent gain expected by analysts. Most retail outlets are reporting same store sales on Thursday.
Dollar General sank after the discount retailer's earnings fell short of expectations as it needed to cut prices on clothes. And Tiffany's also sagged after Deutche Bank downgraded the luxury retailer to "hold" from "buy."
Lions Gate Entertainment jumped after the entertainment company beat earnings expectations, helped by lower distribution and marketing costs. Revenues, however, fell short.
The dollar rose against a basket of currencies. Meanwhile, oil prices declined. U.S. light, sweet crude fell $2.41 to settle at $100.29 a barrel, while London Brent crude slipped $2.20 to settle at $114.53 per barrel.
Precious metals closed mixed. Gold rose 0.4 percent to settle at $1,542, while silver fell 1.6 percent to $37.69.
On the economic front, the Institute for Supply Management's index of manufacturing fell to 53.5 in May from 60.4 in April, the lowest level since September 2009. Analysts expected the index to fall to 57.7.
Construction spending, meanwhile, rose 0.4 percent in April, the Commerce Department reported. But spending in April was revised down to a 0.1 percent gain from the previously reported 1.4 percent gain. Economists surveyed by Reuters had expected construction spending to rise 0.3 percent.
And the private sector added only 38,000 jobs in May, according to a jobs report from Automatic Data Processing and Macroeconomic Advisers, far less than what most analysts had expected. In April, the private sector had gained 177,000 jobs, down from the 179,000 initially reported.
The weak economic news is prompting analysts to cut their forecasts for April non-farm payrolls, which will be released on Friday. Goldman Sachs cut its forecast to a 100,000 gain from 150,000, while Credit Suisse cut its forecast to 120,000 from 185,000.
Economists surveyed by Reuters had expected payrolls to rise by 180,000 in May, down from a gain of 244,000 in April.
Another report showed the planned layoffs rose 37,135 job cuts last month, up 1.8 percent from April, and up 4.3 percent from a year ago, according to Challenger, Gray & Christmas, an outplacement firm.
Wednesday's weak economic data continues a recent trend and the “negative seasonality factor” will likely keep the markets choppy for the “next few months,” said Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research.
However, Detrick said a lot of the economic concerns have already been priced into the markets and he expects stocks to climb in the second half of the year.