Beware the Wall Street optimism, this canny analyst warns

Francis H. M. Kelly is a bit of an iconoclast. This thoughtful Scot is known on Wall Street for his ``unusual'' perspective. Last week, a coterie of portfolio managers gathered at ``The Club'' in the Citicorp Building for a buffet lunch -- and to digest the comments of Oppenheimer & Co.'s inimitable research director.

True to form, Mr. Kelly eschews current market thinking.

Many money managers are betting that the economy is bouncing back, or is about to. They are abandoning their declining-interest-rates, slow-growth strategy of the last year. That tactic called for buying defensive (food), interest-sensitive stocks (utilities, banks, insurance companies).

Now, the ``smart money'' crowd is pursuing basic industry, cyclical companies, and technology stocks -- stocks that benefit as business spending picks up. They've been bolstered by news that computer orders are up slightly for some makers.

This rather abrupt strategy shift caused a huge drop in the Dow utilities index last week. In one day, the utility stocks fell 3.27 percent, equivalent to about a 45-point decline in the Dow Jones industrial average. The utility average continued to tumble the rest of the week.

In heavy trading, the Dow Jones industrial average edged slightly lower. Technology stocks gained ground but the Dow closed at 1,357.08, down 2.46 points for the week.

In Mr. Kelly's humble opinion, investing today on the basis of rising corporate profits tied to a rebounding economy is optimism misspent.

``We're obviously on the brink of a recession,'' he says. Sure, the economic pump has been primed by the growth in the money supply. ``Historically speaking, the odds favor that economic activity will pick up,'' Kelly concedes.

But to date, the money growth and lower interest rates haven't translated into increased penetration of international markets. And while consumers have spent at unprecedented rates, business has held back on capital spending.

Typically, in the latter half of an economic growth cycle, as interest rates come down, business spending picks up. This has not happened yet, and Kelly says it is unlikely to.

So the gas that has kept the economy running -- consumer spending -- is about used up. Consumers have borrowed to the hilt. The debt-to-income ratio is at record-high levels. The strength in housing and durable goods (cars, refrigerators, ovens) is ``unsustainable,'' Kelly says.

By his interepretation, the housing statistics are starting to show a decline.

``People view the 17 percent drop in housing starts in May as a mistake. But it was followed by only a 2 percent rise in June. The truth of the matter is that we've seen the longest housing cycle in postwar history. It's very unlikely to continue to engender new activity,'' says Kelly.

And ``interest rates have not come down enough to offset the climb in housing prices,'' he says. Nor are they likely to. He says short-term interest rates have bottomed out, and many of his colleagues agree. Also, the Federal Reserve Board is unlikely to ease credit further for fear of pushing the dollar down too quickly.

But Kelly's premise is that with less consumer borrowing, there will be more credit available. And by year-end, the dollar will fall 25 percent from its March high. A recession will push that slide to 50 percent by mid-1986.

Some view a dollar drop positively. It will make US manufacturers more competitive with imports and boost foreign earnings. But Kelly says that only after the dollar drops significantly do consumers stop buying imports and start buying domestic products. ``That's a good 12 to 18 months down the road.''

He expects corporate profits to go down this year and next. And he labels this rally in technology issues an ``overlay'' that simply ignores problems within the economy and the industry.

``We're seeing a really serious destruction in the profitability of technology companies. They've lost control of their margins,'' he says. To maintain growth in earnings, computer companies must continually increase sales volume. But competition and low demand have forced them to cut prices to maintain volume, thus cutting earnings growth. He cites Digital Equipment Corporation's 1981 net operating margin of 16 percent -- which has fallen to 7 percent. ``This will continue. And with lower margins, it's

harder to make money.''

Kelly predicts not just near-term economic blues, but a fundamental change: ``There's a high probability the US is moving into the lowest growth phase since the world war.''

Where, then, should investors following this offbeat Oppenheimer savant be putting their money?

Not in bonds, at least in the near term. With a declining dollar, ``I see a downward run in the bond market.''

The stock market should be headed lower too, he says, so choosing stocks will be more difficult. In a slow- or no-growth period, the investment potential lies in restructuring -- mergers, divestitures. ``You've got to go through a lot of stocks and figure asset transfer value. Figure out what a business is worth to a competitor in the industry.'' Chart: Interest Rates. *Yields; Source: Bank of Boston.

Percent Prime rate 9.50 Discount rate 7.50 Federal funds 7.25 3-mo. Treasury bills 7.10 6-mo. Treasury bills 7.30 7-yr. Treasury notes 10.44* 30-yr. Treasury bonds 10.72*

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