Profit-taking also played a part in the market's decline, with investors selling some stocks to lock in gains from this year's rally. The S&P 500 is set to close its strongest yearly performance in more than a decade.
"Year-end activity is clouding reactions to some economic news," said Drew Wilson, an analyst at Fenimore Asset Management in Cobleskill, New York.
He said the market is "taper-schizophrenic" as it tries to second-guess the Fed's reaction to recent economic data.
"I'm not sure the market knows how to react to good and bad news."
Facebook (FB.O), however, closed at its highest since October 25 a day after it was selected to join the S&P 500 index. The change becomes effective after the close on December 20. In Thursday's session, the social network's stock jumped 5 percent to end at $51.83 and helped cap the Nasdaq's loss.
The Dow Jones industrial average (.DJI) fell 104.10 points or 0.66 percent, to end at 15,739.43. The S&P 500 (.SPX) lost 6.72 points or 0.38 percent, to finish at 1,775.50. The Nasdaq Composite (.IXIC) dropped 5.41 points or 0.14 percent, to close at 3,998.403.
Many market participants have expected the Fed to announce a cut in its $85 billion a month in bond purchases in March, but that timeline may have shortened after Friday's better-than-expected November payrolls report and Tuesday's initial agreement in Washington on a bipartisan budget.
Other markets also reacted to the perception of a shorter timeline for the Fed's tapering of its bond-buying stimulus. The U.S. dollar rose 0.4 percent against a basket of major currencies .DXY and spot gold slid 2 percent.
The Fed's policy-setting committee is scheduled to meet for the last time this year on Tuesday and Wednesday.
The market is expected to be more volatile ahead of the Fed meeting. The CBOE Volatility Index (.VIX) closed on Thursday at 15.54, its highest since October 15, and the options market showed a trader purchased 40,000 call options at the 22 strike. The VIX has not traded above 22 this year, though it brushed against that level in June in the wake of a Fed announcement.
Data showing the biggest jump in a year in initial claims for unemployment benefits was mostly ignored as figures were skewed by adjustments for the season and other factors.
Lululemon Athletica Inc (LULU.O) shares tumbled 11.7 percent to $60.39 after the yoga apparel company said fewer customers are visiting its stores and supply-chain issues are hitting sales in the crucial fourth quarter.
Investors also dealt with a flurry of initial public offerings, including Hilton Worldwide Holdings Inc (HLT.N). The stock rose 7.5 percent to close at $21.50 in its first day of trading on the New York Stock Exchange. The IPO was priced at $20 a share.
Food services provider Aramark Holdings Corp (ARMK.N) staged a more impressive debut, up 13.5 percent at $22.70 after going public at $20 per share.
Shares of J.C. Penney (JCP.N) rose 0.8 percent to $8.55. Chief Executive Officer Mike Ullman told Reuters that the department store chain is eliminating or trimming some high-profile brands introduced by former CEO Ron Johnson. Penney intends to use the floor space for its more profitable private-label brands.
Southwest Airlines (LUV.N) was the S&P 500's largest percentage advancer, gaining 4.6 percent to $18.79 after Bank of America Merrill Lynch raised its rating on the airline operator's stock to "buy."
Decliners beat advancers on the NYSE by a ratio of about 7 to 5. On the Nasdaq, winners and losers were almost evenly distributed.
About 6.2 billion shares changed hands on U.S. exchanges, slightly above the 6.1 billion average so far this month, according to data from BATS Global Markets.
