Rising rates, stubborn deficits bring a chill wind to Wall Street

Although it's only October, the chill winds of winter have blown through the stock and bond markets. Last week was particularly cold. The Dow Jones industrial average closed the week at 2,246.73, a record 235.48 point drop in a week that also saw the greatest one-day fall on Friday, of 108.36 points on a record volume of 338.48 million shares. Since its record high of 2,722 in August, the Dow has lost more than 17 percent of its value. Bonds, meanwhile, have hit their highest yields since Nov. 1985.

``Winter has come early to Wall Street,'' observes Alfred Goldman, director of technical market analysis at A.G. Edwards & Co., St. Louis. ``The trouble has started, and we're in it.''

Most observers generally agree that the stock market's fall was long overdue. From August 1982 through August 1987, the Dow had risen 2,000 points. ``The market was ripe for a correction of between 10 percent and 20 percent this year,'' says Monte Gordon, director of research at the Dreyfus Corporation in New York. The five-year-old bull market has experienced little significant correction until this year; a previous correction, in 1984, reached 10 percent. ``You can expect this correction process for the next few weeks,'' Mr. Gordon says.

The market high could not be sustained, for reasons ranging from concerns about rising interest rates to the country's $160 billion federal budget deficit and little reduction in the trade deficit. The country is in its 59th month of recovery, the economy is fairly sluggish, and fears of inflation are great.

On Thursday Chemical Bank raised its prime rate by half a percent, a move matched by Marine Midland Bank on Friday. Such action renews concerns about inflation, especially because this is the sixth hike in the prime this year.

``Interest rates will be forced up whether the Federal Reserve likes it or not,'' says John Connolly, senior vice-president of Dean Witter Reynolds Inc. ``Chemical Bank basically countermanded the Fed,'' which earlier that day brought funds into the banking system through repurchase agreements to try to calm concern about a discount-rate increase. The Fed raised this rate, which is what it charges member banks for loans, in September, the first time in three years.

Another reason for the stock market's fall, Mr. Goldman says, is its valuation levels. ``The high price-earnings ratios, low yields, and book values of this market are levels you see close to the top of a market, not the bottom,'' he explains.

An increase in bond interest rates, which have risen from 8 percent to 10 percent recently, also contributed to the decline. ``This makes for stiff competition between stocks or bonds,'' Goldman says. Interest-rate rises do not augur well for the bond market.

Also, third-quarter corporate results did not reach expected performance levels. ``Many analysts are reevaluating the 1988 economy and earnings projections as a result,'' Goldman notes.

Perhaps one of the most stubborn concerns, which is spilling over to the markets, is the country's $160 billion budget deficit. ``It is becoming more obvious that the United States is acting out the role of the beggar internationally,'' says William Gillard, managing director of investment policy at Kidder, Peabody & Co. ``While people are willing to lend money, they are not willing to lend at low rates. They want to be compensated fairly.''

Because the private sector does not have $160 billion to lend, the country goes hat in hand overseas. In 1985, the Group of Five - France, Britain, Japan, the United States, and West Germany - agreed that each country would play its part in squaring up the international economy. ``The US hasn't taken the steps to ensure the progress in this problem,'' Mr. Gillard notes, ``so the lenders are stepping up action.''

West Germany's central bank, the Bundesbank, and the central bank of Japan have raised their interest rates, Gillard says. ``They are departing from our parade and won't support the dollar the way they did before. Germany particularly is interested in cooling economic activity to prevent reinflation,'' he adds.

The August merchandise trade deficit figure of $15.68 billion, released last week, also affected the market. The falling dollar was expected to cut the monthly figure to anywhere from $13.5 billion to $15 billion.

``Although the trade figures released last week didn't reach the expectation, the trade deficit is improving on a volume basis. This improvement is not showing up in the figures, however,'' says Gordon at Dreyfus. ``The market was looking for good news, and it set up a straw man.''

On top of these factors, there is still a high level of bullishness about the market, which breeds complacency about a sell-off. At market tops, people are still bullish, Goldman says. ``We also have a problem in this market that half of the participants wouldn't know a bear market if it ate their Mercedes,'' he says.

Yet now is not the time for investors to cut and run, Gordon says. ``There is no sign that inflation is taking hold. The market is highly emotional, and fears are not generally warranted. Investors in good stocks should hold their ground, because the market will rebound and will go on to a new high,'' he says.

Mr. Connolly of Dean Witter suggests carrying liquidity and buying less volatile stocks or high-yield stocks, such as utilities, which tend to show performance in a down market. ``Go for earnings in cyclical stocks and interest-sensitive stocks, but not consumer stocks,'' he advises.

The Dow Jones utilities average has not fallen as far as the Dow Jones industrial average, observes Edward Nicoski, managing director for technical research at Piper, Jaffray & Hopwood Inc., in Minneapolis. ``This is a positive divergence, because people are putting money in interest-sensitive stocks, like utilities.''

Two other investment options for this market are fixed-income instruments, which are securities that pay a fixed rate of return, and certain stocks. ``I think the bond market has been overdone on the downside,'' Mr. Nicoski says. ``Perhaps it's time to be a contrarian.''

On the equity side, Gillard advises looking at first-class companies selling internationally: pharmaceuticals and the waste-management companies that are growing quickly. He also suggests the regional Bell Telephone companies, because they are interest sensitive and give protection on a market downside.

For those investors who do not hold stocks, Gillard suggests holding cash - Treasury bills or riskless securities. ``These will prevent damage on the downside and allow you to buy on the upside,'' he explains.

The market's behavior shows that investors have turned to cash. ``One way you raise cash is by selling stocks,'' says Nicoski. ``This is reflected in the Dow being down 11 percent from its high in August, while the over-the-counter issues, or secondary stocks, are down only 6 percent.''

Nicoski is another supporter of the regional Bells and other secondary stocks, particularly technology. Regional banks deserve investors' attention, he adds.

``I think we're near the trading lows,'' he says. ``I think it's going to take some time to get back to August highs; I'm not sure we'll see that by the end of the year.''