But the damage wasn't just in stocks. Bond prices fell, and the yield on the benchmark 10-year Treasury note rose to 2.42 percent, its highest level since August 2011, although still low by historical standards. Oil and gold also slid.
"People are worried about higher interest rates," said Robert Pavlik, chief market strategist at Banyan Partners, while other analysts pointed to panic selling.
The question now is whether the markets' moves on Thursday were an overreaction or a sign of more volatility to come. What is becoming clearer is that traders and investors are looking for a new equilibrium after a period of ultra-low rates, tied to the Fed's bond-buying, which helped spawn one of the great bull markets of all time.
It doesn't mean the stock run-up is over. After all, the S&P 500 is still up 11.4 percent for the year and 135 percent since a recession low in March 2009. But it may suggest the start of a new phase in which the fortunes of the stock market are tied more closely to the fundamentals of the economy.
And that might not be a bad thing. The reason the Fed is pulling back on the bond-buying is because its forecast for the economy is getting brighter.
The job market is improving, corporations are making record profits and the housing market is recovering.
"People are overreacting a little bit," said Gene Goldman, head of research at Cetera Financial Group. "It goes back to the fundamentals, the economy is improving."
The Dow's drop Thursday which knocked the average down 2.3 percent was its biggest since November 2011. It comes just three weeks after the blue-chip index reached an all-time high of 15,409. The index has lost 560 points in the past two days, wiping out its gains from May and June.
The Standard & Poor's 500 lost 40.74 points, or 2.5 percent, its worst session since November 2011. It also reached a record high last month, peaking at 1,669. The Nasdaq composite fell 2.3 percent.
Small-company stocks fell more than the rest of the market Thursday, a sign that investors are aggressively reducing risk. The Russell 2000 index, which includes such stocks, slumped 2.6 percent. The index closed at a record high Tuesday.
The yield on the 10-year Treasury note rose to 2.42 percent, from 2.35 percent Wednesday. The yield, which rises as the price of the note falls, surged 0.16 percentage point Wednesday after the Fed's comments. As recently as May 3, it was 1.63 percent.
A Fed policy statement and comments from Chairman Ben Bernanke started the selling in stocks and bonds Wednesday. Bernanke said that the Fed expects with qualifications to scale back its massive bond-buying program later this year and end it entirely by mid-2014 if the economy continues to improve.
The bank has been buying $85 billion a month in Treasury and mortgage bonds, a program that has made borrowing cheap for consumers and business. It has also helped boost the stock market.
Alec Young, a global equity strategist at S&P Capital IQ, said investors weren't expecting Bernanke to say the program could end so quickly, and are adjusting their portfolios in anticipation of higher U.S. interest rates.
"What we're seeing is a pretty significant sea-change in investor strategy," Young said
For much of the year, the stock market rose with barely an interruption. The S&P 500 climbed for seven months straight from November 2012 through May. Investors, fearful of missing out on the rally, pounced on any dips and pushed markets to record highs. On Thursday, those opportunistic buyers were absent. Nobody wanted to stand in the way of the market's slide.
As investors sold stocks, they likely put the proceeds in cash "for fear the deterioration will continue," said Quincy Krosby, a market strategist at Prudential Financial.
The sharp increase in bond yields prompted investors to sell homebuilders, whose business could be hurt if the pace of home buying slows down. Those stocks fell even though the National Association of Realtors said Thursday U.S. sales of previously occupied homes surpassed the 5 million mark in May, the first time that had happened in 3 ½ years.
PulteGroup plunged $1.89, or 9.1 percent, to $18.87. D.R. Horton fell $2.13, also 9.1 percent, to $21.31.
Markets were also unnerved after manufacturing in China slowed at a faster pace this month as demand weakened. That added to concerns about growth in the world's second-largest economy. A monthly purchasing managers index from HSBC fell to a nine-month low of 48.3 in June. Numbers below 50 indicate a contraction.
A big jump in the overnight lending rate in China also unsettled investors, said Brad Reynolds, a financial advisor at LJPR. The rate measures how much banks charge each other to borrow short-term money. The People's Bank of China was forced to pump about 50 billion yuan, about $8 billion, into the Chinese financial system to alleviate the squeeze, Bloomberg News reported.
Before trading began Thursday on Wall Street, Japan's Nikkei index lost 1.7 percent. The FTSE 100 index of leading British shares fell 3 percent while Germany's DAX dropped 3.3 percent.
In currency trading, the dollar rose to 97.34 Japanese yen from 96.54 yen. The euro fell against the dollar, to $1.3197 from $1.3274.
Gold plunged, leading a rout in commodity prices. Gold dropped $87.80, or 6.4 percent, to $1,286.20 an ounce. Silver fell $1.80, or 8.3 percent, to $19.823 an ounce. Both are at their lowest since September 2010.
Traders dumped gold and silver as their appeal as insurance against inflation and a weak dollar faded. Both became less of an issue after the Fed said it was contemplating an end to its bond-buying program.
Oil was swept up in the sell-off. Crude oil had its biggest one-day price drop since November. U.S. benchmark oil for July delivery sank $2.84, or 2.9 percent, to finish at $95.40 a barrel in New York. Gasoline futures fell more than 3 percent.
Some investors said the sell-off in stocks may be overdone. The Fed is considering easing back on its stimulus because the economy is improving. The central bank has upgraded its outlook for unemployment and economic growth.
The S&P 500 is still up 11.3 percent, for the year, not far from its full-year increase of 13.4 percent last year.
Among other stocks making big moves:
GameStop, a video game store chain that sells new and used games, rose $2.41, or 6.3 percent, to $40.94 after Microsoft backpedaled and said that there will be no limitations on sharing games on its upcoming Xbox One gaming console.
Rite Aid fell 23 cents, or 7.4 percent, to $2.88 after the nation's third-largest drugstore chain lowered its forecast for 2014 earnings. Where is money going? Utahns weigh in
"For the near term a lot of the money will be going to the sidelines as cash. The big question is who are the sellers. Right now it looks like the first ones out were the banks, hedge funds and traders." Toby Levitt, partner and CEO, Albion Financial Group.
"There have been reports that average investors were doing the selling, with the money going into cash simple money market funds. A lot of people appear willing not to make any money rather than risk losing it." James Derrick, chief investment strategist, Smedley Financial Services.
"Stocks and bonds both went down, which you don't see very often. But if you were watching closely, shortly before it closed, prices started rallying. That could mean some people were figuring we've about hit bottom." Ernest Hathaway, financial adviser, Financial Strategies Institute.