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The five-day losing streak for the Dow Jones industrial average was the longest since July.
The Dow dropped 158.20 points to 12,938.11 points, with losses accelerating in the last 20 minutes of trading as reports circulated that President Barack Obama would not be making a new budget proposal in a meeting with congressional leaders.
The Standard & Poor 500 index fell 15.67 points to 1,402.43, its longest losing streak in three months, and the Nasdaq dropped 25.59 points to 2,960.31.
"The reality, late in the day, is that a deal is just not going to get done," said Ryan Detrick, a senior technical strategist at Schaeffer Investment Research. "We could be greeted by a big sell-off at the start of January."
President Barack Obama returned from a Christmas break in Hawaii to meet with congressional leaders at the White House to try thrash out the terms of a deal that would prevent across-the-board tax increases for millions of Americans as well as simultaneous government spending cuts beginning Jan. 1. Those measures, if implemented, could push the economy back into recession, economists say.
Stocks closed lower Thursday but erased most of an early loss after Republicans said they would reconvene the House of Representatives Sunday in hopes of piecing together a last-minute budget deal.
Traders have been focusing on Washington, and the budget negotiations, since the Nov. 6 presidential election returned a divided government to power.
"I can't wait till this is done, so we can start talking about markets again and not just about politics," said Doug Cote, chief market strategist at ING Investment Management. Cote doesn't expect lawmakers will manage to reach a deal before the deadline and says that when people assess the extent of tax increases on the way, "the market is going reel."
Cote also expects slowing earnings growth to hit stocks.
Despite the fiscal gridlock in Washington, major stock indexes are holding on to gains for the year. The Dow is up 5.9 percent, the S&P 500 index is 11.5 percent higher and the Nasdaq is up 13.6 percent.
Stocks rose in 2012 on optimism that a housing market recovery, coupled with an improving job market, will support economic growth. The Federal Reserve has also extended its bond purchasing program, which is intended to lower borrowing costs and encourage spending and investment.
Stocks declined despite reports that suggested the outlook for the economy is improving.
A measure of Americans who signed contracts to buy homes increased last month to its highest level in two and a half years, the latest sign of improvement in the once-battered housing market. The National Association of Realtors said Friday that its seasonally adjusted pending home sales index rose to its highest since April 2010.
The Institute of Supply Management's Chicago-area purchasing managers index for December came in at 51.6, beating estimates for a gain to 51.
Bond prices rose as investors moved money into defensive investments. The yield on the benchmark rise 10-year Treasury note, which falls when bond prices rise, dropped to 1.70 percent from 1.75 percent late Thursday.
Among stocks making moves:
Hewlett-Packard fell 36 cents, or 2.6 percent, to $13.68 after the computer and printer maker said the Department of Justice is investigating H-P's business software unit Autonomy. H-P bought Autonomy for $10 billion in 2011 and has accused the company's former management of fudging its accounting before the acquisition. H-P has lost almost half its market value this year, making it the biggest decliner among the 30 stocks in the Dow average.
Barnes and Noble rose 62 cents, or 4.3 percent, to $14.97 after the U.K. publishing and education company Pearson said it is making an $89.5 million investment in the company's Nook Media division, as the two companies look to make a bigger digital push into the education sector.
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