NEW YORK - US stocks dropped on Friday as investors tempered their optimism that the economy could avoid recession, and locked in profits on banking and pharmaceutical shares after two days of sharp gains.

Bank shares, among this week's biggest gainers, declined as talk of more write-downs related to the sinking housing sector circulated through the market. The S&P financial index dropped 2.5 per cent.

Drug companies, which generally prosper in good times and bad, took a hit on Friday after helping lead the market higher earlier in the week.

Despite the day's declines, the Dow and S&P ended the week higher for the first time in five weeks. The Nasdaq was down for the fifth straight week.

'The economic backdrop hasn't changed, and there is still a high level of nervousness about any headlines that reinforce there is still reason to be concerned about the market's direction,' said Michael James, senior trader at regional investment bank Wedbush Morgan in Los Angeles.

Indices
The Dow Jones industrial average slid 171.44 points, or 1.38 per cent, to end at 12,207.17. The Standard & Poor's 500 Index dropped 21.46 points, or 1.59 per cent, to 1,330.61. The Nasdaq Composite Index lost 34.72 points, or 1.47 per cent, to 2,326.20.

Volatility was high, as it has been all week, with the VIX, an index of market fear, ending up 5.1 per cent.

For the week, the Dow gained 0.9 per cent and the S&P 500 advanced 0.4 per cent, while the Nasdaq slipped 0.6 per cent.

An index of retail shares, also big gainers this week, reversed course and ended down 2.8 per cent on Friday.

The rumours involving the financial sector centred around Europe's ING and Fortis. Traders said there was talk of possible profit warnings. ING and Fortis said they never comment on market speculation.

In the pharmaceutical sector, Merck shares fell US$1.77 (S$2.54) to US$47.79, while Schering-Plough shares dropped US$1.15 to US$19.02.

Stocks started the day higher, boosted by strong earnings from companies including diversified manufacturer and Dow component Honeywell International Inc, which gained 3.7 per cent to US$58.25.

An agreement between congressional leaders and the White House on the outlines of an economic stimulus package on Thursday and a hefty interest-rate cut by the Federal Reserve on Tuesday helped fuel a sharp two-day rebound in US stocks after a global equity rout earlier in the week.

Trading was active on the New York Stock Exchange, with about 1.88 billion shares changing hands, about in line with last year's estimated daily average of roughly 1.9 billion, while on Nasdaq, about 2.63 billion shares traded, ahead of last year's daily average of 2.17 billion.

Declining stocks outnumbered advancing ones by a ratio of about 9 to 7 on the NYSE and by 15 to 13 on Nasdaq. -- REUTERS