A reading below 50 indicates contraction; it was the first service-sector contraction in more than four and a half years. Analysts had been expecting another month of growth.
It's possible that the service sector could bounce back in February, like the manufacturing sector did in January after its troubling contraction in December. The benefit of the Federal Reserve's two big interest-rate cuts in the latter part of January could also help spur the service sector back into growth mode.
Still, the data was especially worrisome given last week's Labor Department report, which showed a net jobs loss in the U.S. economy in January -- the first in more than four years. Together, the two reports indicate that the ongoing credit crisis is dragging down the actual economy.
"The mosaic that we the credit market and also a slowing economy," said Quincy Krosby, chief investment strategist at the Hartford.
Meanwhile, Wall Street's enthusiasm over Microsoft Corp.'s bid for Yahoo Inc. was dissipating. Banc of America Securities lowered its rating on Yahoo to neutral from buy, saying the proposed acquisition could run up against regulatory challenges, according to Dow Jones. The bank said regulatory difficulties could be steepest in the European Union.
In the first hour of trading, the Dow fell 169.65, or 1.34 percent, to 12,465.51.
Broader stock indicators also dropped sharply. The Standard & Poor's 500 index fell 20.61, or 1.49 percent, to 1,360.21, while the Nasdaq composite index fell 30.09, or 1.26 percent, to 2,352.76.
Bond prices jumped as investors sought the safety of government-backed debt. The yield on the benchmark 10-year Treasury note, which moves opposite its price, sank to 3.54 percent from 3.64 percent late Monday.
The dollar was higher against most other major currencies, while gold prices fell.
Light, sweet crude oil was down $1.74 at $88.38 a barrel on the New York Mercantile Exchange, as traders bet that a slower economy could dampen energy demand.
The Russell 2000 index of smaller companies fell 7.80, or 1.08 percent, to 715.66.
Stocks also retreated overseas. Japan's Nikkei stock average closed down 0.82 percent and Hong Kong's Hang Seng index fell 0.89 percent. In afternoon trading, Britain's FTSE 100 fell 1.84 percent, Germany's DAX index fell 2.54 percent, and France's CAC-40 fell 2.72 percent.
