Word on Wall Street: Proceed With Caution

Fed's hike in short-term interest rates leaves investors skittish

THE word on Wall Street is ``be wary,'' as the investment community awaits a clearer picture as to whether inflation still threatens the United States economy.

``Investors don't know whether inflation is likely to be as bad as the Federal Reserve Board suggests it is, or will be,'' or whether the Fed's latest interest rate hike ``will be enough'' to put inflation behind us, says Dennis Jarrett, chief market analyst for investment house Kidder, Peabody & Co.

This is a time of ``waiting and watching,'' Mr. Jarrett says, as Wall Street attempts to sort out the direction of the US economy, as well as the future course of interest rates.

Since the Fed raised short-term rates for the sixth time this year on Nov. 15, the market has been highly volatile. Last week, more stocks were losing value, rather than gaining.

``Bonds now rule the roost,'' says Larry Wachtel, a vice president with Prudential Securities Inc. ``When interest rates rise, as they are now doing, that creates intense competition for stocks,'' as investors seek out returns from higher-yield fixed instruments.

Wall Street ``momentarily forgot it's history that stocks don't sit very well when the Fed decisively raises interest rates,'' and thus pushes up bond yields, says Gene Jay Seagle, president of Tactics and Technics, a market consulting firm in Weston, Conn. ``The Fed's rate increase turned out to be far higher than the street had expected. In fact, [it was] the highest single increase since 1981.''

Most investment houses, he says, were expecting a half point increase in the federal funds rate, which banks charge each other for overnight loans. ``Instead, the Fed raised the rate three-quarters of a point. That has now hit home,'' Mr. Seagle says. ``The question here is whether the Fed will do all this again'' in December or January.

So how will investors react?

``A lot of investors are going to just sit on the sidelines,'' Seagle says. ``I've been bullish about the stock market, and I still think the major trend is up. But now there are enough uncertainties to suggest a pause for most investors, until everything becomes clearer.''

The market, as measured by the Dow Jones industrial average, has already had to struggle to wrest out gains this year. On Jan. 31 of this year, the market reached its all-time high of 3,978.36 points. But since then, the Dow has cascaded up and down, largely staying below the 3900 point level. The market has recently been trading around the 3800 point level. On Friday, the market closed at 3,815.26, up 13.79 points for the week.

Given all the brouhaha here about interest rates, the Dow has only managed to eke out a 2 percent gain this year. That increase has been based largely on advances within industrial stocks linked to the strong economic expansion under way in the US, Europe, and Asia.

Now, if the Fed manages to slow the US economy, future gains for industrial stocks, including higher corporate profits, could be more difficult to attain.

But right now there appears to be no ``strong leadership underway in the market,'' in terms of dominance by any one sector, Jarrett says. While much of the recent heavy trading has been linked to program trading, there's a ``distinct lack of direction'' for individual sectors.

Thus, some analysts believe that December could be a difficult month for stocks, as investors watch the Fed for clues as to future monetary policies.

Next year, however, could be more promising for many market sectors, given the change in congressional leadership, some analysts suggest. Granted, these analysts are concerned that congressional Republicans and the Democratic White House might take joint action to initiate a middle class tax cut. That would not be popular on Wall Street, since a major tax reduction might boost the federal deficit and thus further drive up interest rates.

On the other hand, Wall Street welcomes much of the anticipated Republican agenda, including a reduction in the capital gains tax, welfare reform, reduced spending on entitlements, and some increases in defense spending, such as for missile defense.

Moreover, the incoming Republican Congress is not likely to pursue hearings into the huge tobacco, insurance, and drug industries, as a Democratic-led Congress would have, suggests Prudential analyst Barbara Dreyfuss, in a new study. Philip Morris, for example, has already posted market gains since the election.

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