U.S. stocks plunged on Monday as investors fled to the safety of gold and bonds the first trading day after Standard & Poor's downgraded the United States.

U.S. stocks lost as much as 5 percent by mid-afternoon and European stocks hit a two-year low. Wall Street's favored gauge of investor anxiety spiked well above 40, a sign investors are afraid of more declines to come. The CBOE Volatility Index <.VIX> was up 39.4 percent at 44.60.

Investors were struggling to discern the effects of the U.S. credit rating downgrade, which could hit various components of the vast U.S. financial sector, from mortgage lenders to municipal issuers and insurers.

When you get this kind of panic and fear into the market, it goes beyond any realistic or sensible level. I wouldn't put all my money in stocks right now. I'd hold some back, said Mike Gibbs, chief market strategist at Morgan Keegan in Memphis, Tennessee.

Investors took shelter in the asset that was downgraded -- choosing U.S. government bonds for their liquidity and perceived high quality.

The downgrade -- and the threats of subsequent moves by S&P or other rating agencies -- raise uncertainty as to the credibility of the United States in the global economy as investors increasingly worry about another recession.

Central to S&P's argument was that political paralysis in Washington has reached a point where the government would be unable to deal with worsening deficits and sagging economic growth. This burdens a stock market already skittish after last week's outbreak of fear.

President Barack Obama blamed the downgrade on political gridlock in Washington and said he would offer some recommendations on how to reduce federal deficits.

In many ways this is not about the downgrade. I think it's about the underlying fundamentals and issues that are embodied in the downgrade itself, said Jonathan Golub, chief U.S. equity strategist at UBS in New York.

MSCI's all-country world stock index <.MIWD00000PUS> dropped 4.9 percent and to its lowest since September 2010. The sell-off since July 29 has wiped at least $3.4 trillion off the value of global stocks, the equivalent of Germany's gross domestic product.

The sell-off crowded out any relief from news that the European Central Bank was buying Italian and Spanish government bonds in the latest move to staunch the euro zone debt crisis.

SEARCH FOR SAFETY

Several major brokerages have in recent days lowered their expectations for U.S. economic growth and share appreciation for 2011 and 2012.

Moody's repeated a warning it could downgrade the United States before 2013 if the fiscal or economic outlook weakened significantly but said it saw the potential for a new deal in Washington to cut the budget deficit before then.

Investors looking for a safe place to park their money pushed gold to a record high above $1,700 an ounce. The dollar dropped against the Swiss franc and yen, while the euro fell.

The euro hit a record low against the Swiss franc, falling as low as 1.0640 Swiss francs. It also lost 1.8 percent versus the yen.

The dollar fell 1 percent to 77.57 yen and was down 2.1 percent at 0.7507 Swiss francs.

The 30-year U.S. Treasury bond was last trading up 3-4/32 points in price and yielding 3.69 percent, down from Friday's close at 3.85 percent. The benchmark 10-year Treasury note was last up 2-1/32 in price and yielding 2.34 percent, down from 2.57 percent late on Friday.

European shares closed down 4 percent after registering gains on the ECB action. The FTSEurofirst 300 index <.FTEU3> has lost about 21 percent since a peak in mid-February, putting it in bear market territory.

The Dow Jones industrial average <.DJI> dropped 538.87 points, or 4.71 percent, to 10,905.74. The Standard & Poor's 500 Index <.SPX> slid 71.11 points, or 5.93 percent, to 1,128.27. The Nasdaq Composite Index <.IXIC> slumped 152.01 points, or 6.00 percent, to 2,380.40.

There have been 26 other days since 2000 when the market has been down more than 3 percent at noon, according to Birinyi Associates Inc. On average, 85 percent of the time the market continues lower until the close for a further 1 percent fall.

(Additional reporting by Chuck Mikolajczak and Edward Krudy in New York and Atul Prakash and Jeremy Gaunt in London; Editing by James Dalgleish)

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