Stocks dropped on Thursday, driving indexes down more than 2 percent on growing fears that the euro zone's handling of its sovereign debt crisis could jeopardize the global economic recovery.

The S&P 500 is now down more than 10 percent from its April high, signifying a correction and marking the most significant break in the rally from March 2009's 12-year low. The index is also below its 200-day moving average.

The correction comes on the back of a stream of negative news out of Europe, from worries over Greece's debt crisis to Germany's unilateral decision this week to ban naked short-selling.

This is just investor fear and panic setting in, said

Mike O'Rourke, chief market strategist at BTIG LLC in New York.

One of the problems is the European policy-makers have done a very poor job handling this whole crisis ... and the poor response has further undermined investor confidence.

Banks and commodity-related stocks were among the hardest hit, with the KBW Bank index <.BKX> losing 2.7 percent. The S&P Energy index <.GSPE> fell 2.7 percent, while June crude futures fell 2.7 percent, or $1.86, to settle at $68.01 a barrel in volatile trade on the day of its expiry.

The Dow Jones industrial average <.DJI> fell 223.10 points, or 2.14 percent, to 10,221.27. The Standard & Poor's 500 Index <.SPX> tumbled 26.77 points, or 2.40 percent, to 1,088.28. The Nasdaq Composite Index <.IXIC> lost 60.78 points, or 2.64 percent, to 2,237.59.

At these late afternoon trading levels, the indexes had pared some of their earlier steep losses, when the Nasdaq was down as much as 4.31 percent at a session low of 2,203.50. The S&P 500 had hit an intraday low at 1,073.11, a drop of 3.76 percent, while the Dow slid to a session low of 10,087,58, down 3.42 percent.

Large manufacturers' shares ranked among the heaviest weights on the Dow, with Caterpillar down 2.3 percent at $60 and 3M falling 2.2 percent to $80.74.

May individual equity options and some options on stock indexes stop trading at Friday's close and expire on Saturday, which may increase volatility.

The Chicago Board Options Exchange Volatility index <.VIX>, often referred to as Wall Street's fear gauge, surged 31.3 percent earlier to 46.37, its highest intraday level in more than a year. But the VIX later retraced some of that gain and was up 20 percent at 42.38 in late afternoon trading.

Sears Holdings Corp tumbled 8.7 percent to $90.91 after the company said first-quarter profit slipped 38 percent, hit by weaker margins and slightly higher costs.

One rare gainer was the stock of upscale U.S. home-goods retail store chain Williams-Sonoma Inc , which rose 5 percent to $29.87 after reporting an adjusted first-quarter profit that easily beat expectations.

Negative data added to the downward momentum with the number of U.S. workers filing new applications for unemployment benefits unexpectedly rising last week for the first time since early April.

And in more evidence the economy is encountering some headwinds, the index of leading economic indicators slipped last month for the first time March 2009, while factory activity in the U.S. mid-Atlantic region accelerated less than expected in May.

(Reporting by Leah Schnurr; Editing by Jan Paschal)

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