The S&P 500 and the Nasdaq tumbled Wednesday as plunging microchip shares, in the face of potential escalation of U.S. trade conflicts with China, exacerbated the ongoing rotation out of megacap tech-related stocks.

A report that the Biden administration is considering severe trade restrictions against China sent microchip stocks lower.

A pullback in the "Magnificent 7" group of momentum stocks, led by Nvidia and Apple, dragged the Nasdaq and the S&P 500 sharply lower.

The Dow Jones Industrial Average, which has until recent days underperformed the other two indexes this year, held onto a modest gain and logged its third straight record closing high.

The blue-chip average got a boost from Johnson & Johnson , UnitedHealth Group and, in defiance of the swooning chip sector, Intel Corp.

"(The sell-off) is being driven by pressure in the chip area, and the first time, we're actually seeing it extend into small caps," said Michael Green, chief strategist at Simplify Asset Management in Philadelphia.

"The U.S. is increasingly talking about cracking down (on China), which has exacerbated the unwind that had already started," Green added. "Many of the areas (of the equities market) that had been neglected are experiencing discriminatory buying."

The smallcap Russell 2000 which surged 11.5% in the previous five sessions, snapped its longest winning streak in over four years, driven by renewed interest in more undervalued stocks and sectors within the equities market.

Signaling growing investor anxiety, the CBOE Market Volatility index briefly hit its highest level in six weeks.

Here is a look at the extent to which megacap momentum stocks and chips have outperformed the broader market this year:

On the economic front, housing starts and building permits surprised to the upside, as strength in multiple-unit projects offsets a dip in single-family homebuilding.

In a separate report, industrial output rose at double the expected rate in June.

The data fell in lock-step with recent reports suggesting that despite signs of softening, U.S. economic resiliency will help the Federal Reserve bring inflation down to its 2% target without tipping the economy into contraction.

On Wednesday, the Federal Reserve released its Beige Book, which showed U.S. economic activity expanded at a modest pace from late May through early July, but reported signs the jobs market continues to soften.

"The narrative has shifted a little bit," said Chuck Carlson, chief executive officer at Horizon Investment Services in Hammond, Indiana. "The economy looks like (it is) on a course for soft landing, and thus let's buy the economically sensitive stocks."

Financial markets have priced in a 93.5% probability that the Fed will begin cutting rates in September, according to CME's FedWatch tool.

But monetary policy makers, while acknowledging the central bank is getting closer to cutting rates, many would prefer to see more data confirming that inflation is on a sustainable downward path.

Second-quarter earnings season is gathering steam, with Johnson & Johnson posting better-than-expected profit and revenue driven by strong drug sales.

United Airlines is due to report shortly.

According to preliminary data, the S&P 500 lost 79.47 points, or 1.40%, to end at 5,587.73 points, while the Nasdaq Composite lost 512.41 points, or 2.77%, to 17,996.45. The Dow Jones Industrial Average rose 242.38 points, or 0.59%, to 41,196.86.

Among the 11 major sectors of the S&P 500, technology suffered the largest percentage drop on the day.