Stocks fell on Tuesday after a prominent banking analyst warned the sector's fundamentals have yet to improve, and an unexpectedly large drop in wholesale inventories raised worries about an economic recovery.

Financial stocks, which had gained about 25 percent in the last month, tumbled after Rochdale Securities analyst Richard Bove painted a gloomy outlook for the banking industry. He said bank stocks are trading on fumes, and he expects a short-term pull-back in their stock prices.

Banks aren't out of the woods yet, said Kevin Kruszenski, Head of Listed Trading at KeyBanc Capital Markets in Cleveland.

There are some worries about additional equity that needs to be raised. The market is going to have a hard time moving meaningfully higher without them, Kruszenski said.

The drop in wholesale inventories in June, which was nearly double expectations, suggests that businesses remained skeptical about a return in demand.

A report late Monday from the Congressional Oversight Panel, a U.S. bailout watchdog, which underscored difficulties still facing the banking industry, also weighed on bank stocks. The panel said toxic loans and securities continue to pose a threat to the financial system, particularly for smaller banks that face mounting losses on commercial real estate loans.

The Dow Jones industrial average <.DJI> dropped 75.95 points, or 0.81 percent, to 9,262.00. The Standard & Poor's 500 Index <.SPX> fell 10.84 points, or 1.08 percent, to 996.26. The technology-laced Nasdaq Composite Index <.IXIC> slid 20.43 points, or 1.03 percent, to 1,971.81.

The financial sector of the S&P 500 <.GSPF> shed 2.8 percent while the KBW Bank Index <.BKX> was down 4 percent.

As earnings season draws to a close, investors were also cautious as a two-day monetary policy meeting by the U.S. Federal Reserve got underway Tuesday. Also weighing was a report on July retail sales, due Thursday.

Earnings reports are due this week from retailers Wal-Mart Stores Inc , J.C. Penney Co Inc and Macy's Inc , which may provide investors with some insight as to whether consumer spending, which accounts for roughly two-thirds of the U.S. economy, is stabilizing.

Another worrying sign of a still-weak economy came from hedge fund firm Atticus Capital LLC, which told investors that it is closing two of its three funds and would return $3 billion to shareholders.

Adding to losses for financials, Miller Tabak cut its price targets on Zions Bancorp and Regions Financial Corp . Shares of Zions dropped 8.6 percent to $16.38, while Regions dropped 3.8 percent to $4.78.

The S&P Regional Banks sub-index <.GSPBNKS> slipped 4 percent.

The negative news overshadowed better-than-expected data on U.S. non-farm productivity in the second quarter, which showed worker productivity rose as hours worked fell much more steeply than output.

(Editing by Padraic Cassidy)

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