Inflation prospects bring out the bears on Wall Street

Inflation jitters are turning Wall Street topsy-turvy - again. Just two weeks ago, the Dow Jones industrial average raced to a record high of 2,722.42. But an abrupt change in perceptions has rapidly shoved down the 30 industrials 6.5 percent.

Bond prices have tumbled, too, as interest rates arc skyward. Yields on long-term government bonds have topped 9.6 percent. (Bargain hunters propped up the markets Wednesday, but the swirl may not be over.) Many analysts say interest rates are heading higher.

``The momentum is there; I think yields will rise to 10 to 10.5 percent in the next few weeks or months,'' says Raymond Worseck, chief economist at A.G. Edwards & Sons, a St. Louis-based brokerage firm.

That doesn't bode well for prospective home buyers or holders of variable-rate mortgages. For example, in two weeks Commonwealth Mortgage Company in Wellesley, Mass., has raised its 30-year fixed-rate mortgage a full percentage point, to 10.995 percent.

``If the trade deficit numbers are larger than expected, we could see even higher rates,'' warns Commonwealth president John Sousa.

Economists suspect that the July balance-of-trade figures due out tomorrow will show no improvement. If so, the dollar could continue to weaken against other currencies and help perpetuate the upward trend in interest rates.

Lyle Gramley, chief economist of the Mortgage Bankers Association, also thinks rates are headed higher, but for different reasons. Mr. Gramley, a former Fed governor, says the economy is showing signs of renewed vigor, especially in the industrial sector. ``Industrial employment is up, orders are up, and production is rising.'' He believes that in another month or two, those increases will show up in better trade shipment figures.

As for inflation, Gramley says that ``it isn't threatening to break out immediately, but the potential for it in 1988 is real.'' He predicts that ``within the next month to six weeks, we could see another increase in the discount rate to keep the economy growing at a rate that keeps inflation under control.''

Last Friday, the Federal Reserve Board, under its newly appointed chairman, Alan Greenspan, pushed the discount rate (what the Fed charges financial institutions for loans) from 5.5 to 6 percent. While serving to establish Mr. Greenspan's role as an inflation fighter, the increase merely validated a rise that had already taken place in the money markets, says Abby Joseph Cohen, a Drexel Burnham Lambert investment strategist, voicing the prevailing view.

There's a d'ej`a vu sense about the financial markets' reaction to these developments. Last spring, bonds and to a lesser extent stocks took a similar nose dive, and interest rates shot up when currency traders lost confidence in the dollar. A weakening dollar, coupled with rising commodity prices, sparked expectations of higher inflation.

The Fed did not raise the discount rate, but it did admit later to quietly ``snugging'' up on credit to bolster the dollar. Over the summer, the financial markets regained their footing. But the spring debacle hurt bondholders.

How should investors deal with this round of market gyrations?

``It would be hard to turn down double-digit yields on high-quality bonds with an inflation rate of 5 to 6 percent,'' says Mr. Worseck at A.G. Edwards. ``I'm more comfortable with buying bonds than stocks at the moment,'' he concludes.

Mrs. Cohen at Drexel disagrees. ``Don't rush out and buy bonds here unless you happen to be a trader. Individuals might look for any near-term decline in interest rates [a rise in bond prices] to take profits in their bond funds. Longer term, economic growth means the basic trend in rates is up.''

But the bull market in stocks isn't over yet, according to Cohen. She remains high on industrial-sector stocks. And Martin D. Sass shares her optimism.

``This correction, like others, will prove to be a buying opportunity. I don't think the Dow's going to 5,000, but it does have the firepower to go to 3,000,'' says the head of M.D. Sass Investor Services, a large New York money management firm.

A continued rise in stock prices, Mr. Sass says, will be fueled by two factors: strong corporate profits and excess liquidity.

First- and second-quarter profits for the companies comprising the Standard & Poor's 400 index rose a whopping 19 and 26 percent, respectively. ``That's the first time in over 40 years we've had two consecutive quarters of double-digit earnings gains,'' he notes.

Sass expects a 27 percent year-to-year gain in third-quarter profits and an 81 percent jump in the fourth quarter (tax-induced write-offs hurt 1986 second-half profits).

Next year, Sass predicts, profits will increase 15 percent. For the Dow 30 industrials that translates into $186 a share. With a price/earnings multiple of 16.5, Sass figures that puts the Dow at a ``fundamentally attainable'' 3,069.

He further supports his case with excess liquidity numbers. Corporate mergers and stock buybacks have shrunk the supply of equities by $237 billion since 1983, and they continue apace. As a result, the stock market capitalization has been reduced about 8 percent. At the same time foreign buying continues to increase. This year it has risen to an annual rate of $41 billion through July, compared with $18 billion last year.