How can Wall Street rise again?

A Federal Reserve interest-rate cut, expected tomorrow, is seen as critical.

When times are good on Wall Street, investors find ways to shrug off bad economic news the same way a spouse learns to ignore a snoring mate.

But when times are bad, as they are now, almost any negative development - a poor earnings report, a downturn in the Japanese economy - sends the stock market down.

So, what will it take to calm a volatile market and get it moving in the right direction?

If the past is any guide, shellshocked investors will need proof that the economy is picking up. Confidence-boosters would be signs that Americans are once more flocking to car dealers to make a deal. Or that homebuyers are stepping out this spring with an eye for a larger house with a two-car garage. And that businesses are talking expansion and hiring, not contraction and layoffs.

Most important, the Federal Reserve, which meets tomorrow, will have to lower interest rates to reassure Americans that it feels their pain.

"The next six to eight weeks are pivotal," says Joe Battipaglia, chairman of investment strategy at Gruntal & Co. in New York. "If some positive evidence begins to mount, there could be a stampede back into the market."

At this point, plenty of cash is sitting on the sidelines, enough to fuel a sharp stock-market rally. At last count, some $2.5 trillion sat in short-term money market funds. As interest rates fall further, the returns on those funds will drop. "I view it as hot money waiting to move back into the market," says Mr. Battipaglia.

But first, investors will have to feel confident that those funds won't just disappear as they did last week, when the Dow Jones Industrial Average lost 208 points, the worst drop in value since 1989. The high-tech-oriented Nasdaq index is down about 60 percent from its high, and the broader-based Standard & Poor's 500 Index is off 25 percent.

By historical standards, the broad index has fallen by a level that is typical of other bear-market corrections (except 1973 to 1974, when the market shrank for an extended period of time).

In the past, sharp interest-rate cuts have helped drive away investor blues. The only recent exception was in 1974, when the economy was struggling with high oil prices. But in 1987 and again in 1998, the Fed dropped rates significantly to spur the economy.

"That's a necessary condition to rebound," says Mark Zandi of Economics.com, a website. "It always takes Fed easing to pull out."

The Federal Reserve is expected tomorrow to lower interest rates either by half a percentage point or perhaps as much as three-quarters of a point. Since the beginning of January, the Fed has dropped rates by 1 percent. But it had raised interest rates by 1.25 percentage points between 1999 and 2000.

Lower rates could make a big difference to struggling companies. For example, many companies have overproduced and are now carrying large inventories. Many businesses are spending well above their cash flow and need loans to meet their payrolls.

"If interest rates come down, it relieves the debt burden and makes it easier for banks and others to extend credit," says Mr. Zandi.

The stock market is anticipating an aggressive easing by the Fed, says Duncan Richardson, senior vice president at Eaton Vance, a Boston-based mutual-fund group. Without a major inflation problem, he says there is no reason why the Fed can't reduce interest rates. "Interest rates are going to be lower a year from now, and that's a very bullish thing," says Mr. Richardson.

Still, lower interest rates alone will not necessarily turn the market around. Wall Street likes to have some sense of accuracy in forecasting corporate earnings. In recent weeks, company after company has announced that earnings will be below expectations. This has shaken investor confidence.

"In terms of the technology companies, you have no idea of demand for the next few months or quarters - you can't analyze them in terms of an earnings rebound," says Don Berdine, chief investment officer at PNC Investment Advisors in Pittsburgh. One example of this from a positive standpoint: Last Thursday, Nokia, the Finnish telecom company, said it would meet its earnings goals, and this helped spark a stock rally in Europe, which spread to the US in the morning.

The market will also have to get past the month of April, which from a historical standpoint has not been very good because some investors need to sell stocks or bonds to pay their tax bills.

The month will also give investors a clearer look at the economy. They will begin to see if the Fed's interest-rate cuts are starting to have an effect. But there may also be more bad news, since the market losses have been so steep that some economists are concerned consumers won't make major purchases.

"It's uncanny - if you look at consumer spending versus the Nasdaq stock prices, there appears to be a real correlation," says Mr. Berdine. If consumers decide to retrench, then he says the economy may be looking at a recession.

"It may be April 'til we clear the decks here."

(c) Copyright 2001. The Christian Science Monitor

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