TORONTO - Steep losses returned to stock markets with a vengeance Tuesday as investors hit the sell button after data showed the U.S. service sector going into contraction mode, persuading investors the U.S. economy is shrinking.

"The report drives a nail into the coffin from investors' minds that we're in a recession,'' said Todd Salamone, director of trading at Schaeffer's Investment Research in New York.

Financial stocks also took a hit on the latest round of concerns about more writedowns of securities linked to soured American mortgages.

Toronto's S&P/TSX composite index retreated 326.21 points or 2.5 per cent to 12,931.95.

In New York, the Dow Jones industrials tumbled 370.03 points or 2.93 per cent to 12,265.13 on top of a 108 point drop Monday that added up to the blue chip index's worst two-day slide in five years.

The TSX Venture Exchange was down 57.76 points to 2,509.97.

The Canadian dollar fell 1.38 cents to 99.29 cents US as the greenback strengthened against a wide range of currencies including the euro, the British pound and the yen.

The Nasdaq composite index fell 73.28 points or three per cent to 2,309.57 while the S&P 500 index dipped 44.18 points to 1,336.64.

Markets had been poised for a negative session with traders ready to take more profits out of a two-week long rebound that followed a series of selloffs during January.

But sentiment worsened after the Institute for Supply Management non-manufacturing index slumped to 44.6 in January from 54.4 in December. It was the first time in almost five years that the ISM had recorded shrinkage in service activity, which accounts for two-thirds of the economy.

The financial sector lost more ground following an announcement from Fitch Ratings that it plans to lower the ratings on more than half of the US$220 billion wrapped up in collateralized debt obligations.

Further downgrades would mean the securities, many backed by mortgages, are worth even less than previously feared. That could cause more problems for struggling banks, brokerages, and bond insurers.

Meanwhile, CIBC World Markets warned that more mortgage-related writedowns in a slowing U.S. economy will likely send stock markets down further.

"We're talking about another US$30 to US$50 billion worth of asset writedowns by North American banks over the next quarter,'' said chief strategist Jeff Rubin, cautioning that this could knock stock markets down another five per cent.

"We're still going to see further house price declines, further rises in delinquency rates, further negative home equity being created and further more asset writedowns.''

The Toronto stock market is down more than 11 per cent from its record high at the end of October and has lost more than six per cent since the start of the year.

The TSX financial sector continued to lose ground Tuesday, down 1.92 per cent. TD Bank (TSX:TD) headed $1.34 lower to $66.55 while CIBC (TSX:CM) dropped $1.64 to $70.

The base metals sector was Tuesday's lead decliner, down 4.7 per cent. Teck Cominco Ltd. (TSX:TCK.B) gave back $2.18 to $34.63 and Fording Canadian Coal Trust (TSX:FDG.UN) declined $2.55 to $45.80.

The TSX energy sector was 2.6 per cent lower as the March crude contract on the New York Mercantile Exchange declined $1.16 to US$88.41 a barrel. Suncor Energy (TSX:SU) lost $3.20 to $92.78, and EnCana Corp. (TSX:ECA) gave back $1.10 to $66.91.

Husky Energy Inc. (TSX:HSE) reported an 18.5 per cent rise in 2007 profit to $3.2 billion, exceeding expectations, but its shares slipped 92 cents to $41.26.

The stronger greenback pressured gold prices. The TSX gold sector moved down 2.1 per cent as the April bullion contract on the Nymex faded $19.10 to US$890.30 an ounce. Kinross Gold Corp. (TSX:K) fell 32 cents to $21.05.

On the upside, Shoppers Drug Mart Corp. (TSX:SC) ran ahead $2.11 to $49.63 after it raised its dividend while reporting fourth-quarter profits jumped 16 per cent to $227.9 million, helped by a rise in sales.

CGI Group Inc. (TSX:GIB.A) was down 14 cents to $10.16 after a 66 per cent increase in quarterly net income to $72.6 million as revenue edged up 1.1 per cent to $914.7 million, held back by the strong Canadian dollar.

Franchise Services of North America Inc. (TSXV:FSN), owner of the U-Save and Rent-A-Wreck banners, was subjected to a cease-trade order because of late financial reporting blamed on the complexity of combining its U.S. and Canadian operations.

On the TSX, declines beat advances 1,108 to 436 with 205 unchanged as 331.3 million shares traded worth $6.77 billion.