Wall Street's Query: Is a 'Correction' Close?

IT has been an exciting week for stock-market investors. By closing time on Wednesday, the Dow Jones industrial average was down 196.9 points, or about 3.5 percent.

"We have been telling our clients for some time that it would not be unnatural for there to be a correction [slump]," says Michael Flament, an analyst at Wright Investors' Service, an investment-management firm in Bridgeport, Conn. "By the law of averages, one is due. Maybe that is what is happening now."

If so, many analysts suspect stock prices will fall further. Mr. Flament says perhaps by a total of 10 percent. The last time the market took a 10 percent hit was in October 1990.

Several factors have made investors edgy:

Interest rates have risen. Thirty-year Treasury bonds yielded 6.94 percent at mid-week, the highest since last August.

"That's hefty competition for stocks," says William Freund, an economist at Pace University, New York, and former chief economist of the New York Stock Exchange.

Since 1929, stocks have on average returned about 10 percent a year. But dividing anticipated 1996 earnings of the 500 stocks in the Standard & Poor's index into their cumulative price at the end of March, stocks this year should "yield" 5.8 percent, Flament estimates. That's less than no-risk Treasury bonds.

Further, higher interest rates cost business money and imperil the strength of the economic expansion.

"We have had a sharp drop in mortgage applications already," notes Christopher Low, an economist with HSBC Markets Inc., a brokerage firm in New York. This could trim house construction. And higher rates may reduce business profits, key to stock prices.

Investors have been spooked by some hints of more inflation. The producer price index for March rose 0. 5 percent, causing some alarm. It reflected higher energy and farm commodity prices. Mr. Low says the increase in oil prices recently is equivalent to a $100 billion new consumption tax. Households and businesses, since they must pay more for gasoline at the pump or fuel oil to heat their homes and offices, have that much less money to spend on other goods or services. Mr. Low expects a 0.4 percent rise in the March consumer price index, announced today.

There has also been a rise in average hourly earnings in the first two months of the year. That, says Low, has prompted some concern about greater wage pressures stimulating inflation.

With widespread predictions late last year and early this year of a further economic slowdown or even a recession, the Federal Reserve was expected to lower interest rates further. But the growth in new jobs in February and March prompted Fed policymakers to take no action at their March meeting, and, many observers suspect, no action anytime soon.

Most analysts figure that stock prices won't take a long time to rebound from a slump. And many anticipate a recovery in bond prices and lower interest rates later this year. "Over 1996-97, we believe that the fundamentals support our expectation of positive real returns from high-quality stocks and bonds," Flament says.

For example, Susan Hickock, chief economist with Prudential Economics in Newark, N.J., sees oil prices dropping as the demands of a hard winter in the United States and Europe fade. She is forecasting real growth in national output at a 2.4 percent annual rate in both the first half and second half of this year. And she says inflation this year will remain under 3 percent.

Low is less optimistic, seeing the possibility of an actual tiny decline in real gross domestic product (GDP), the nation's output of goods and services, in the first quarter if statistics, when released, show the deficit in the balance of trade to be as bad in February and March as it was in January. He's forecasting a mere 1 to 1.5 percent gain in GDP for the year.

Dr. Freund sees a second half "slowdown" in the economy.

One precaution: The quarterly forecast of economists as a group was far less than accurate last year and so far this year.

Mutual-fund managers have had difficulty beating the performance of the S&P 500 stocks last year. Flament holds that the popularity of index funds that attempt to match that index has driven up the price of stocks within the index. On average, the price of stocks in the index is 17.2 times 1996 projected earnings. Portfolios that include many "quality" stocks outside the S&P 500 can have a considerably lower price-earnings ratio.

Flament sees a buying opportunity in this P/E gap.