Bonds and stocks both say, `You go first'

Acting a bit like Laurel and Hardy, the stock market listened carefully last week, while the bond market gave the orders and did most of the talking. Two weeks ago ``the bond market went into a tailspin because of the discount rate rise by the Fed,'' says Wayne Wong, a managing partner at Marinvest, a money-managing subsidiary of Marine Midland Bank. ``Now the equity people look at bond people and say, `If they're worried, gee, shouldn't we be worried about it too?'''

Equity markets last week responded to the bond market's ambivalence about the future of the economy and interest rates, analysts say. Each market looked at the other and continued to wallow in uncertainty following the decision two weeks ago by Federal Reserve chairman Alan Greenspan to kick up the discount rate from 6 to 6.5 percent.

Amid concern that Mr. Greenspan might in coming months make another move to cool the economy to prevent inflation, bond prices remained unenthusiastically flat or lower last week.

Reflecting that uncertainty, the Dow Jones industrial average ran at a low volume, with many investors on the sidelines, and settled Friday at 2,016.00, down 21.52 points for the week. That is down from higher volumes and the Dow's previous operating range above the 2,100 level two weeks ago. Economic indicators show a robust economy and industrial output rising. That should be good news for the market. But investors are wary of the Fed's proclivity to use higher interest rates to keep inflation under a rock amid strong corporate earnings and a rising producer price index.

``The strength of corporate profits is a little like a double-edged sword,'' says John DeSantis, director of research at Independence Investments, a Boston portfolio management company affiliated with the John Hancock Life Insurance Company. ``It's good to be earning more money and to have strong business trends. But on the negative side is the feeling that the Fed looks at that strength and feels the need to control inflationary expectations by raising interest rates.''

When interest rates are rising, the stock market gets hit with a double whammy as company earnings are eaten into by the higher cost of borrowing money. Stocks are also less attractive, relative to short-term, fixed instruments like certificates of deposit, which offer high rates of return without the risk inherent in stocks.

``When buying common stock, you're buying a stream of future dividends,'' Mr. DeSantis says. ``When interest rates go up, the present value of future dividends falls'' and stock prices suffer.

Several analysts believe the bond market, which has been leading the stock market around by the nose, is looking for some sign, some numbers, to tell it if the economy is strong - or not. If the economy is strong, that lends credence to the theory that the Fed will raise the discount rate again before the year ends.

If the economy is really weaker than everyone currently believes, then the Fed will let it ride. Evidence supporting the contention that the market is actually weaker than presumed would make everyone a bit happier. The bond market would also probably rebound, releasing its psychological hammerlock on stocks.

``Our scenario sees an economy that is chugging along, but not booming enough to worry about inflation,'' says Deborah Johnson, a senior economist with Prudential-Bache Securities Inc. She cites relatively low levels of wage inflation, running at 3 to 3.5 percent, and productivity increases in manufacturing.

``In times of good productivity, we don't worry about inflation,'' Ms. Johnson says. ``The bond market just gets like this every now and then - very worried about inflation. A few numbers will come along, and everything will go back to normal.''

Newton Zinder, a technical analyst with Shearson Lehman Hutton Inc., thinks the bond market's fears are probably illusory. ``I think the stock market will prove to be right,'' he says. In the fall, there will be signs that the economy is slowing as interest rates rise, he says.

``There are no signs yet, but my guess is that after Labor Day, corporate earnings and back-to-school sales will be disappointing,'' Mr. Zinder says. ``It should lend some credence to the fact that the economy is not as strong as everyone thinks, and the Fed won't have to tighten up.''

With a market running on ambiguity and basic lack of interest, it might seem like a bad time to be buying stocks. But there may be opportunities for longer-term investors, says Jack Demaree, a vice-president with Thompson & McKinnon Securities Inc. in St. Louis.

``I'm trying to recommend utilities, and companies with low debt and strong market identification like Gerber,'' Mr. Demaree says. ``I'm not talking just blue chips, but companies with good franchises like Bob Evans restaurants, McDonald's, Wal-Mart. These are companies that people go to in good and bad times.''