TORONTO - The Toronto stock market tumbled as investors took profits from the five-month-old rally following a warning about the financial sector's health and ahead of Wednesday's interest rate announcement by the U.S. Federal Reserve.

The S&P/TSX composite index dropped 164.2 points to 10,629.47.

The TSX loss followed a 92-point slide Monday. However, the Toronto market is still ahead more than 40 per cent since the start of the rally in early March, reflecting general optimism that the economy is recovering.

"We have seen a massive runup in the market, which probably got a little bit ahead of itself, certainly when you compare it to historical rallies from a bear market low and there's some good profits to be had out there," said Philip Petursson, director of institutional equities at MFC Global Investment Management.

He added that the markets have surged lately on sentiment rather than fundamentals and expects a correction "over the next month or so."

The financial sector was the leading decliner, down 2.6 per cent with Royal Bank (TSX:RY) down $1.23 to $49.48. Scotiabank (TSX:BNS) gave back $1.42 to close at $44.05.

CI Financial Corp. (TSX:CIX) fell 70 cents to $20.20 after the mutual fund and asset management company reported a 62 per cent drop in second-quarter profits as sales of its investment funds declined.

Financial sector losses picked up following comments from U.S. analyst Richard Bove of Rochdale Securities, who said that U.S. bank earnings are unlikely to improve in the second half and that many firms may post losses. He said investors should lock in profits after a surge in bank stocks since early March.

Also, U.S. bank CIT Group warned of "substantial doubt" regarding its ability to continue as a going concern, due to "on-going stress in the credit markets, operating losses, credit ratings downgrades, and regulatory and cash restrictions." In New York, its shares plunged 28 cents or 18.9 per cent to US$1.20.

The Canadian dollar closed down 1.06 cents to 90.79 cents US as the American dollar continued to rally in the wake of Friday's much better than expected jobless report for last month.

The energy sector lost 1.67 per cent as the September crude contract on the New York Mercantile Exchange moved down $1.15 to US$69.45 a barrel. Canadian Natural Resources (TSX:CNQ) eased $1.62 to $62.22.

The TSX Venture Exchange declined 8.37 points to 1,176.84.

American traders also pulled back as the Dow Jones industrial average moved 96.5 points lower to 9,241.45.

The Nasdaq composite index lost 22.51 points to 1,969.73 while the S&P 500 index slipped 12.75 points to 994.35 as the Fed started its scheduled two-day meeting on interest rates Tuesday.

It is widely expected that the Fed will hold interest rates steady at near zero, but investors are waiting to see what the central bank has to say in its assessment of the economy when the meeting concludes Wednesday.

"I think there will be a bit of optimism in their report," added Petursson, pointing to a lack of pricing pressure and improving jobless numbers.

The TSX base metals sector lost 0.9 cent as the September copper contract edged 3.2 cents lower to US$2.7365 a pound.

The gold sector was down slightly as the December bullion contract rose 70 cents to US$947.60 an ounce.

Bombardier Aerospace (TSX:BBD.B) shares were down 27 cents to $4.06 after the company cancelled an order from Italy's My Air for 15 of its CRJ1000 aircraft as the carrier faces an "uncertain situation." Italy's civil aviation authority suspended My Air's licence last month due to financial troubles at the airline.

On the Canadian economic front, Canada Mortgage and Housing Corp. said the seasonally adjusted annual rate of housing starts decreased to 132,100 units in July from 137,800 units in June, mainly because of weakness in the multiple starts segment.

In earnings news, hardware and home improvement retailer Rona Inc. (TSX:RON) says a drop in housing starts led to a seven per cent dip in second-quarter sales and a reduction in profits for the period. Rona booked profits of $60.8 million, down from $76.6 million a year ago and its shares added two cents to $14.35.

Shares in Leon's Furniture Ltd. (TSX:LNF) rose five cents to $10.10 after the Toronto-based retailer said its profit last quarter was $8.62 million, 26 per cent lower than the same time last year. Total sales including franchise stores fell to $209.9 million from $224.7 million, a decline of $14.7 million.

Tissue maker and cardboard producer Cascades Inc. (TSX:CAS) said Tuesday it turned a profit of $30 million during the second quarter despite a modest dip in sales. The showing reversed a year-earlier loss of $25 million and its shares jumped 50 cents to $5.80.

After the market closed, Brookfield Asset Management (TSX:BAM.A) and Brookfield Properties (TSX:BPO) announced a plan to form a $4-billion consortium with other institutional investors to invest in under-performing real estate in several regions of the world.

Brookfield has allocated $1 billion to the consortium with opportunities in the office sector being funded by Brookfield Properties and opportunities in other sectors being funded by Brookfield Asset Management.