NEW YORK ( TheStreet) -- Stocks kicked off October on a down note Monday as fears of sovereign debt contagion in Europe took on new life as Greece said it likely won't meet its deficit-reduction target for 2011.

The nervousness sparked heavy selling in U.S. banks as investors worried about overseas exposure and overwhelmed any excitement about a better than expected read on U.S. manufacturing. The SPDR KBW Bank ( KBE) fell nearly 5%, and Bank of America ( BAC) dropped nearly 10%, falling below $6 for the first time since March 2009. Energy stocks were also weak as oil prices dipped to their lowest levels in more than a year.

The Dow Jones Industrial Average finished down 258 points, or 2.4%, at 10,655. The S&P 500 was off by 32 points, or 2.9%, at 1099, closing below a key technical level of 1120. The Nasdaq lost 80 points, or 3.3%, to settle at 2336. All three major equity indices closed at or near their session lows.

The challenges that plagued the market in recent months showed little signs of easing. The Dow and S&P 500 both lost more than 10% during the third quarter, making it their worst performance since the 2008-2009 financial crisis. Economic data has continued to point to sluggish growth that could tip the U.S. economy back into another recession.

"Since we're right in front of earnings season, there are a lot of cross currents going on," said Robert Pavlik, chief market strategist with Banyan Partners. "Institutions and retail investors are largely out... Short term traders, hedge funds and high frequency traders are driving the market."

On Monday, the electronic traded funds Energy Select Sector SPDR ( XLE) and Financial Select Sector SPDR ( XLF) lost 2.4% and 3.1%, respectively. Bank of America, Alcoa ( AA) and JP Morgan ( JPM) were the worst performers on the Dow. Wal-Mart Stores ( WMT) was the only blue-chip to finish in positive territory.

Only 13% of the 6 billion shares trading on the New York Stock Exchange gained ground while 86% were declining. Some 2.6 billion stocks changed hands on the Nasdaq.

A modest improvement in September manufacturing data allowed U.S. stocks to rally briefly in the morning. The Institute for Supply Management's manufacturing index rose to a reading of 51.6 from August's level of 50.6. Economists had projected a lower reading of 50.5, according to Briefing.com.

However, while the headline number exceeded expectations, the improvement was in part due to businesses fulfilling backlog orders, but not increasing orders on new products. "Once you dig into the report, it's not as good as it seems," says Pavlik at Banyan Partners. "That is giving the market a bit of pause."

In other economic news, construction spending increased by 1.4% in August after dropping 1.4% in July, according to the Department of Commerce's report. The market had been anticipating a decline of 0.5%.

In a Monday blog post, RealMoney contributor Jim Cramer said that investors will never be able to focus on the U.S. until Europe agrees on a unified plan to resolve its debt crisis.

"Without some resolution, the great numbers like we had today just can't keep us from rolling over...yet. One day we will come in here with a down opening and rip up and stay up, but that will not be until Europe is at last scared into the kind of action we took three years ago today. At the time, no one really knew how TARP would work. But it was the beginning of the end of the nightmare," he said.

Over the weekend, Greece said that its deficit will likely make up 8.5% of its gross domestic product in 2011, higher than the 7.8% level it had targeted before. The admission from the Greek finance ministry sparked renewed fears that the country will not get approval for its next tranche of loans, necessary for Greece to avoid a default in October.

In Europe, London's FTSE lost 1%, and Germany's DAX sunk 2.3%. Japan's Nikkei Average closed lower by 1.8% and Hong Kong's Hang Seng plummeted 4.4%.

AMR Corp ( AMR), the parent of American Airlines, tanked 33%, halted trading several times on Monday, amid talk that the airline may be forced into bankruptcy. Analysts worry that AMR, the third largest U.S. airline, may be especially hard hit by the economic downturn. The company reported a loss of $286 million in second quarter while its rivals posted profits.

In other corporate news, electronic payments firm ACI Worldwide ( ACIW) is acquiring payments products company S1 ( SONE) for $9.55 a share, which represents an increase of 42 cents a share in cash from ACI's previous offer. Shares of S1 fell 1.2% to $9.06 while ACI's stock was off by 8.3% at $25.26.

Arch Coal ( ACI) cut its 2011 earnings outlook to an adjusted profit of $1 to $1.40 a share late Friday, lower than the earnings of $2.02 a share that analysts had been projecting. The company blamed lost metallurgical coal production at its Mountain Laurel facility. Shares lost 9.3% to $13.22.

Shares of Eastman Kodak ( EK) soared 72% to $1.34. Following speculation that the company could be filing for bankruptcy, the company issued a statement late Friday assuring that it is committed to meeting all of its obligations and does not intend to go bankrupt..

Yahoo! ( YHOO) gained 2.7% to $13.53 after Alibaba Chairman Jack Ma expressed strong interest in acquiring the company.

Shares of General Motors ( GM) climbed 3.5% to $14.69 on news that September sales rose by 20% to 207,145.

The benchmark 10-year Treasury rose 1 8/32, diluting the yield to 1.783% as the Federal Reserve kicked off 'operation twist" on Monday. The dollar was strengthening slightly against a basket of currencies, with the dollar index up by 1.04%.

The November crude oil contract settled down by $1.59 to $77.61 a barrel. Elsewhere in commodity markets, gold for December delivery gained $35.40 to trade at $1657.70. The lift came after investors sold off gold to cover for losses in equities, pushing prices down 11% in September.

-- Written by Chao Deng and Melinda Peer in New York.

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