Shades of August? Just over a month ago, interest rates were coming down, a lickety-split economy was tempering, and it appeared inflation was in check. So went the wisdom on Wall Street. Lo and behold, the stock market erupted.
The market dillydallied as it waited for further assurances. A few points up one day, a few down the next, but drifting slowly lower. With lethargy came notes of pessimism and then uncertainty as a brief post-Labor Day rally fizzled.
But confidence springs eternal, it seems. Last week, the Dow Jones industrial average tested the 1,200 mark and held firm, before bouncing upward almost 28 points on Thursday, recording its greatest gain in a month. The Dow closed Friday at 1237.52, up 30.14 in five trading sessions.
What brought the bulls back?
For two weeks now the Federal Reserve has been pumping reserves into the banking system. By Thursday, the bond market rallied on a growing belief that the Fed may be moving to bring interest rates down.
Allan Sinai thinks such an interpretation is premature.
''I think the Fed has been putting reserves back to offset overzealous draining last month. It is not a fundamental change in their stance, yet,'' says Mr. Sinai, chief economist at Shearson Lehman/American Express.
Nonetheless, he thinks this rally is on firm ground. The M-1 money supply plunged $2.1 billion for the week ending Sept. 3, surprising many analysts. The drop of this measure of ready cash is seen as an indication of a slower economy and bridled inflation.
Other indicators released Friday buttress a belief that the economy is heading where the Fed wants it to go.
Retail sales fell 0.8 percent in August after plummeting 2 percent in July, according to the Commerce Department. The drop marked the first back-to-back declines since February and March.
The Federal Reserve Board reported that factory output rose just 0.2 percent last month. It was the smallest increase in 10 months. These figures taken together help confirm that the economy is moderating its pace of growth, economists say.
A sign that inflation remains on a tight leash was evident when the Labor Department reported that wholesale prices dropped 0.1 percent in August - the first decline since November. Cheaper food and oil pushed down the index, which measures changes in the prices of nearly 3,400 categories. Wholesale price trends eventually show up at the retail level.
''There are clear indicators that we have a surprise building for third-quarter GNP, and it's exactly the kind of news the fixed-income market needs to hear,'' says Mr. Sinai.
The stock market may be cocking an ear and acting on such news too, says Alfred Goldman, senior vice-president and market analyst at A. G. Edwards & Sons in St. Louis.
''For the next four to five weeks the direction of least resistance is up. The next problem will come at about 1,250, but I think we'll overcome that and revisit highs of 1,287 or so,'' Mr. Goldman opines.
Long-term investors should hitch their harnesses to aerospace, restaurant, food, and health-care stocks, he says. For speculative traders, he recommends ''top-quality growth stocks and interest-rate-sensitive issues, such as banks and savings-and-loans.''
Although bullish, Goldman doesn't think this market has the oomph to push beyond the 1,300 mark. ''I see a lot of fundamental and technical problems at that point.''
He cites uncertainity over the presidential election and the composition of Congress, the federal budget deficit, a 21/2-year-old recovery, and the historically high interest on bonds which will continue to give stocks severe competition for the investor dollar.
The strong yields on bonds is also a concern at Prescott, Ball & Turben, a Cleveland-based brokerage. ''We're cautiously optimistic but not really bullish, '' says analyst Rao Chalasani. ''Bonds still have very heavy yields. If you're picking a stock, you're going to have to pick stocks that will compete with bonds - such as the blue chips,'' he says.
A decline in interest rates is the key to bringing bond yields down and in turn fueling a rise in stock buying. Economist Sinai expects such a credit-loosening move by the Federal Reserve shortly.
''In the next two weeks to a month, I think an easing by the Fed is likely.'' He looks the prime rate, now at 13 percent, to fall to 12.5 percent.
One chart: Interest rates. Source: Bank of Boston.
Prime rate 13.00
Discount rate 9.00
Federal funds 11.46
3-Mo. Treasury bills 10.78
6-Mo. Treasury bills 11.14
7-Yr. Treasury notes 12.48
30-Yr. Treasury bonds 12.18