* U.S. labor costs post largest gain in more than 5-1/2 years
* Fear over earlier Fed interest rate rise spurs selling
* Investors fret over Argentina default fallout, Russia tensions
* Dow down 1.9 pct, S&P 2 pct, Nasdaq 2.1 pct (Updates close with Dow negative for the year, latest volume)
By Caroline Valetkevitch
NEW YORK, July 31 The U.S. S&P500 stock index posted its worst daily fall since April and its first monthly drop since January on Thursday, as economic data sparked concern the Federal Reserve could raise interest rates sooner than some have expected.
Data showing that U.S. labor costs recorded their biggest gain in more than 5-1/2 years in the second quarter this year came a day after the Fed upgraded its assessment of the U.S. economy while reiterating it was in no hurry to raise rates.
Problems in overseas economies added to the bearish tone, with Argentina defaulting on its debt for the second time in 12 years.
"If we start to see wages moving higher that's got a be a signal that we are getting closer to the Fed's mandates," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.
The Fed has kept overnight rates near zero since December 2008, but at its meeting on Wednesday it took note of both faster economic growth and a decline in the unemployment rate, while expressing concern about remaining slack in the labor market.
On Thursday, all 10 S&P500 index stock sectors fell more than 1.0 percent, with energy down 2.4 percent leading the decline. Exxon Mobil Corp's second-quarter earnings beat expectations but oil production dropped, and its shares fell 4.2 percent to $98.94.
The CBOE Volatility index, often referred to as Wall Street's fear gauge, jumped 27.2 percent to close at 16.95, its highest level since April 11.
The Dow Jones industrial average fell 317.06 points or 1.88 percent, to 16,563.3, while the S&P 500 lost 39.4 points or 2.0 percent, to 1,930.67 and the Nasdaq Composite dropped 93.13 points or 2.09 percent, to 4,369.77.
Trading volume was much heavier than average. About 8 billion shares changed hands on U.S. exchanges, well above the 5.6 billion average for the month to date, according to data from BATS Global Markets.
The stock price falls pushed the Dow into negative territory for the year. It is now down 0.1 percent since Dec. 31, while the S&P500 and Nasdaq are still higher for the year to date.
The S&P500 and Nasdaq both marked their biggest daily percentage drops since April 10. For the Dow, the percentage drop was the biggest since Feb. 3.
In a signal of possible further weakness ahead, the S&P500 index closed below its 50-day moving average for the first time since April 15.
For the month, the Dow was down 1.6 percent, the S&P 500 was down 1.5 percent, and the Nasdaq was down 0.9 percent.
Investors on Wednesday had hoped for a midnight deal in Argentina's debt talks with so-called holdout creditors, but the plan fell through. Even a short default will raise companies' borrowing costs, add to pressure on the peso, drain the country's dwindling foreign reserves and fuel what is already one of the world's highest inflation rates.
In Russia, news agencies reported that Russia banned soy imports from Ukraine and may restrict Greek fruit and U.S. poultry in what could be responses to new Western sanctions over Ukraine.
In after hours trade, shares of LinkedIn jumped 8.9 percent to $196.70 when the corporate networking site reported a 47 percent increase in quarterly revenue and forecast better-than-expected adjusted profit and revenue in the current quarter.
During the regular session, Kraft Foods Group shares fell 6.4 percent to $53.59. The stock was the biggest percentage decliner on the Nasdaq after Kraft late on Wednesday reported a scant rise in quarterly revenue. (Additional reporting by Rodrigo Campos; Editing by Leslie Adler)