New York — Bad news is good news on Wall Street.
Instead of driving stock prices down, the prospect of a weaker-than-expected economy is pushing them up, as investors anticipate lower interest rates.
The Federal Reserve Board, bullish traders now say, will further loosen the reins on credit to give the economy some running room. When interest rates fall, institutions often put their money into the stock market in an attempt to get the best return on their investment.
They did just that on Wednesday and again on Thursday when the Dow Jones industrial average surged in a two-day ''buying panic'' similar to the sessions that swept the Dow up 150 points in August.
Behind this surge, says economist Mitchell Held of Smith Barney, Harris Upham & Co. is the belief that the Fed shifted its attitude when its Federal Open Market Committee met on Tuesday.
''The economy is in far worse shape than the Fed was hearing,'' says Mr. Held , ''and they decided they did not want to restrict reserves.'' By restricting reserves, the Fed would act to boost interest rates.
Mr. Held said he expected the Fed to lower the discount rate - the interest rate it charges member banks - today from its current 10 percent level. Any cut by the Fed would be interpreted by money managers as confirmation of a policy shift toward lower interest rates.
Until the Fed's meeting on Tuesday, Wall Street economists were not certain how the Fed would react. Kenneth C. Froewiss, an economist with Goldman Sachs, notes that despite an initial estimate that real gross national product grew 1.5 percent in the third quarter, most incoming data continue to show signs of weakness. Retail sales, durable goods orders, housing starts, and industrial production all fell in August. Any increase in economic activity, he reasons, would be due to involuntary liquidation - as merchants and businesses sell off inventory at depressed prices.
Against this background of low economic activity, Mr. Froewiss notes, the Fed was faced with a money supply that was running at the top of its target. Now it appears the Fed has decided to ignore this target, figuring that with the economy operating at low levels, inflation is not a major concern. Thus, it will manage interest rates, not money-supply numbers.
The reaction in the long-term bond markets to this realization was swift. Bond prices rose and yields fell substantially. Noted Frank Mastrapasqua, an economist at Smith Barney, ''Traders have suddenly realized that the decline in short rates will persist and the returns in the short-term markets are unacceptable.'' Thus, he notes, the rally in the bond market helped to add more fuel to stock market.
But it wasn't just lower interest rates that made Wall Street pop. For example, there is still a considerable amount of skepticism about the ability of the stock market to climb higher. Robert Stovall, first vice-president at Dean Witter Reynolds, notes that of the investment advisers who write market newsletters, some 47.2 percent of them were still bearish.
And in his Oct. 2 newsletter, market commentator Joseph Granville was still predicting the Dow would fall to 500. However, when the predicted ''October massacre'' did not materialize, comments Mr. Mastrapasqua, traders began to buy stocks. Some of the buyers, notes Mr. Stovall of Dean Witter, were institutions who missed the first run-up in the stock market and did not want to miss what some analysts are calling the second leg of the bull market. Mr. Stovall says many individuals at Dean Witter sold into the market's rise while the institutions were buying.
However, some of the buying power that jolted the August markets has begun to dry up. Robert Farrell, vice-president and chief market analyst at Merrill Lynch & Co., says that in a recent survey of 125 of the largest institutions, the firm found the group as a whole had 12.3 percent of its assets in cash. At the last survey in the end of June it had 16.1 percent of its assets in cash.
Mr. Farrell concludes ''There has been a sharp drop in cash reserves and some of the buying power has been used up. Thus, the probabilities of the market following through are diminished.'' Mr. Farrell expects the stock market to rise to the 970-to-975 level and then go through a 3-to-6 month period of ''reappraisal of what the economy will really show.''
Over the longer term, many analysts predict a better stock market. Leon Cooperman, a widely respected market strategist at Goldman Sachs, believes the stock market rally in August is just the beginning of a bull market. ''The bulk of the bull market - in terms of price and and time - still lies ahead of us,'' he told his clients at the end of September.
In an interview, Mr. Cooperman noted that the average bull market was from 21 /2 to 3 years in duration and from trough to peak gained 65 percent. ''If we have begun a classical bull market,'' he states, ''by 1984, the Dow would rise from its low point of 777 to 1,300.''