New York — For months Wall Street has been like a dungeon. Investors in the stock market have felt imprisoned by high interest rates. But even now that interest rates have started to fall, investors, like prisoners out on parole, are exercising caution.
In the two weeks since the Federal Reserve Board started to take its foot off the money supply brake by lowering the discount rate, from 12 percent to 111/2 percent, the Dow Jones industrial average has declined more than 25 points. The discount rate is the interest rate Federal Reserve member banks charge on loans to other member banks.
Only the Fed's latest easing, when it further lowered the discount rate to 11 percent on Friday, July 30, and a drop in the prime interest rate to 15 percent - its lowest level in two years - have perked up investors. On Monday, the Dow soared 13.51 points but failed to follow through on Tuesday, when it gave back 5 .71 points. The lack of follow-through, says Martin Zweig, publisher of a stock market newsletter, ''is disappointing.''
The main reason behind the caution, says Frank Parrish, senior vice-president of the Boston-based Fidelity Management Trust Company, is that Wall Street fears that corporate earnings and dividends are still vulnerable. ''People get so tied up with interest rates,'' says Mr. Parrish, ''that they forget that earnings and dividends will also determine stock prices.''
And Monte Gordon, director of research at the Dreyfus Corporation, a mutual fund, says Wall Street has been cautious since it feels the Fed is easing interest rates because the economy is so weak. ''There is a feeling the best the Fed can do is to prevent a severe recession,'' Mr. Gordon says. ''Considering the fragile position of the credit markets, there's not a great deal the Fed can do to bring about a strong recovery.''
On Tuesday, in fact, the bond market had trouble digesting some $6 billion of three-year Treasury notes. Wall Street analysts have been concerned that the credit markets will not be able to absorb the $100 billion in financing the Treasury has said it will offer in the second half of this year.
By next March, when many analysts expect the economy to be in a recovery, the government will borrow up to $12.5 billion per week. The prospect of financing of this magnitude, says William Sullivan, vice-president at the Bank of New York , runs the risk of ''producing severe congestion in all but the most favorable of market situations.'' For investors the risk is clear: Weakness in the bond market quickly spills over to the stock market, as happened on Tuesday.
And even though interest rates are dropping, many observers expect them to rise again this fall and winter as credit demands pick up. ''It seems quite probable that any drop in interest rates will be quite temporary,'' says Erich Heinemann, a vice-president at Morgan Stanley & Co. He says this seesaw pattern of interest rates ''is one of the key factors lying behind my forecast of a weak and unstable economy in 1983.''
Despite such forecasts, which are fairly common on Wall Street, Mr. Parrish of Fidelity says he thinks the economy will show some resilience later this year. Corporate profits, which have been in a steady state of decline, will rebound, he says, since corporations have pared both inventories and expenses. Thus, any pickup in business will ''shoot straight to the bottom line'' for corporations. Mr. Parrish says his confidence is reflected in Fidelity's portfolios, which are fully invested in the stock market.
Gary Capen, executive vice-president at the Minneapolis-based St. Paul Advisers Inc., says he is also relatively optimistic. ''I think all the bad news is out on the table,'' he comments, noting that ''investors know about the $140 billion deficit and all the banking problems.'' Although he concedes the market may fall still further, it hasn't stopped him from buying bonds or selected stocks for the St. Paul's aggressive pension fund accounts.
Mr. Zweig says such buying might be a bit premature. His technical models turned bearish after the market failed to follow through on Tuesday. ''I like what's happening with interest rates,'' says Mr. Zweig, who is a regular panelist on the Public Broadcasting System's ''Wall Street Week'' television program. ''But I don't like the tape action. With interest rates coming down, the market should have been booming.'' Zweig says only 35 to 40 percent of the $ 100 million in pension money he runs is invested in the stock market.
Still, as Richard B. Hoey, an economist at Bache Halsey Stuart Shields Inc., points out, short-term interest rates have fallen sharply in recent weeks. Ninety-day Treasury bills are now yielding only 9.70 percent - the first time investors have seen single-digit yields in two years. Only two months ago, similar short-term Treasury bills were yielding 12 to 13 percent. Thus, yields for money market mutual funds, which have garnered over $200 billion in investors' funds, will start to drop shortly as interest rates on their short-term investments come down.
Mr. Hoey is hopeful that as rates fall, investors will start to funnel some short-term investments into both the long-term bond and stock markets. ''The key to me,'' he says, ''is that (Federal Reserve chairman) Paul Volcker believes we've turned the corner on the underlying rate of inflation.'' Thus, Hoey says the Fed now believes it can have a somewhat easier monetary stance without inflationary blowoff.