The Wall Street stocks retreated on Thursday after an index of factory activity worsened unexpectedly, adding to concerns that the US economy is falling into a recession.

The major indices rose in early trade but energy companies later led a sell-off as crude oil prices declined from recent highs. Banking stocks also came under pressure on worries about earnings prospects.

An analyst upgrade of Cisco (NASDAQ:CSCO) and a higher subscriber forecast from Research In Motion initially boosted optimism in the technology sector but this rally also fell victim to waning confidence.

The S&P 500 closed down 1.3 per cent lower at 1,342.51 points, having climbed 0.6 per cent when the market opened. The Dow Jones Industrial Average gave up 1.2 per cent to 12,284.30 as General Motors (NYSE:GM)’ shares slumped 4.9 per cent amid the growing economic malaise. The Nasdaq Composite fell 1.2 per cent to 2,299.78.

Equities reversed course after the Philadelphia Federal Reserve’s February manufacturing index deteriorated unexpectedly from minus 20.9 to minus 24. The reading was the worst contraction in factory activity since February 2001 and came as an unpleasant surprise for analysts who had forecast an improvement.

The report dampened nascent hopes that if a US recession occurred this year it would likely be short-lived.

David Rosenberg, North American economist at Merrill Lynch, said the “shockingly weak Philadelphia Fed manufacturing survey tells us [a recession] likely will be much worse than 2001 and more like the 1990-style”.

The negative tone of the report seemed to confirm that US manufacturers are struggling. Many investors hoped manufacturers would avoid the worst effects of a domestic economic slowdown by growing revenues overseas, helped by a weak US dollar.

An example of this trend is Terex (NYSE:TEX), a construction equipment maker, which said non-US sales accounted for 70 per cent of 2007 sales, abetting a 72 per cent rise in fourth-quarter earnings. The stock was the best performing on the S&P, rising 7.3 per cent to $66.73.

Separately, an index of leading economic indicators fell 0.1 per cent, marking a fourth consecutive drop, in line with expectations. Weekly jobless numbers also offered little by way of consolation, falling only 9,000 to 349,000 after the previous week’s figures were revised higher.

Although equities slumped on Thursday, the overall trend has been tentatively higher in spite of acute turmoil in credit markets. Some analysts have argued that stocks probably reached a bottom in January, but others remain far less sanguine.

“There’s going to be a more significant downturn than people are willing to admit at this point,” Jeff Buetow, chief investment officer at XTF Global Asset Management, said.

One problem is that many strategist think earnings estimates are too optimistic. Tobias Levkovitch, chief US equity strategist at Citi Investment Research, said sell-side analysts’ bottom-up numbers imply 16 per cent earnings growth in 2008 while Citi’s top-down 2008 earnings per share estimates reckon on a near 2 per cent decline in S&P 500 earnings.

Citi believes estimates are likely to be cut, which could restrain markets this year.

Investors took profits in the materials sector, even as a host of commodities, including gold and platinum, soared to new highs.

The big move in gold was a boon for Newmont Mining (NYSE:NEM), the world’s largest gold producer. The shares fell 1 per cent to $50.64 after Newmont swung to a $289m net loss in the fourth quarter as it took a $1.1bn non-cash charge related to reserve replacement results.

Retailers were broadly weaker with Safeway (NYSE:SWY) among the leading fallers after fourth-quarter earnings fell from a year ago when results benefited from tax adjustments. The group’s same-store revenue growth slowed and shares fell7.1 per cent to $29.66.

JC Penney rose 0.2 per cent to $48.03 after the department store operator said fourth-quarter earnings fell less than expected.

Technology stocks outperformed on Thursday after Citi Investment Research up-graded Cisco from “hold” to “buy” because it said the sector would be less affected by a consumer-led economic downturn than in 2001-02. Cisco’s shares were flat at $23.19.