The U.S. services sector contracted less severely in April and was back to its October 2008 level, a report showed on Tuesday, adding to evidence the world's largest economy was nearing bottom and moving closer to recovery.

The Institute for Supply Management's non-manufacturing index rose to 43.7 from 40.8 in March. That was better than economists' forecast of a smaller increase to 42.0 but still below the level of 50 that separates contraction from expansion.

The data came as Federal Reserve Chairman Ben Bernanke told a congressional committee the economy would begin to turn up later this year.

Basically this is what the market has been anticipating. The contraction is slowing. The rate of slowing is slowing, said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey.

However, the ISM also released a grim 2009 outlook that was a reminder of the heavy toll of the recession. It severely downgraded its projections for economic activity and investment during 2009, in both the manufacturing and services sectors.

On Wall Street, stocks slipped as investors booked profits a day after the S&P 500 turned positive for the year.

U.S. government bonds, which generally perform poorly on signs of improving economic conditions, were slightly lower on the day.

STILL CONTRACTION

The services sector represents about 80 percent of U.S. economic activity, including businesses like banks, airlines, hotels and restaurants.

Though it was the seventh consecutive month of contraction for the ISM non-manufacturing index, there were signs of a positive trend.

Anthony Nieves, chairman of the ISM non-manufacturing business survey committee, was cautious about the results of the report overall.

We need to see how this trends out over the next month or two, Nieves said in a teleconference with reporters.

He added: It's a slower rate of contraction but still contraction.

The details of the report showed substantial improvements in gauges measuring employment and new orders.

Despite the rise, however, the employment index remained mired in a slump, at 37.0 versus 32.3 in March.

The broader view in the ISM's semi-annual report also reflected the deep economic destruction caused by the current recession, which is on track to be the longest post-World War Two slump.

ISM said it expects a 22.7 percent plunge in capital investment for U.S. factories this year, more than three times worse than its previous projection issued in December of a 6.7 percent decline.

The group also said that non-manufacturing firms will see a 13.5 percent drop-off in new spending, far weaker than the 8.4 percent fall predicted in the last survey.

Still, there were faint signs of economic healing in other data released on Tuesday.

U.S. chain store sales rose 0.3 percent in the week ended May 2 versus the same week a year ago, Redbook Research said. However, sales slowed last week amid concern over the spread of swine flu, it added.

Chain store sales also rose 1.5 percent in April versus March.

According to a separate retail gauge released by the International Council of Shopping Centers and Goldman Sachs, chain store sales were up 0.7 percent in the May 2 week but down 0.8 percent on the year.

(Additional reporting by Nick Olivari and Ryan Vlastelica; Editing by Dan Grebler)

Manufacturing New Jersey Ben Bernanke