Interest Rate Upturn Makes Markets Edgy

SHADES of Frankenstein, Dracula, and other Hollywood monster movies: The inflation bogyman is suddenly rearing his head on Wall Street.

Late last week both the bond and stock markets exhibited signs of weakness following reports of possible new inflationary pressures in the United States economy.

Most economists see only modest inflation ahead. The consensus of 50 economists surveyed by Blue Chip Economic Indicators in Sedona, Ariz., is that the Consumer Price Index will increase only 2.8 percent this year and 3.2 percent in 1995.

Nonetheless, yields on 30-year Treasury bonds rose slightly on inflationary concerns, while bond prices dropped. Stock indexes wobbled downward, based on jitters about the bond market.

But few Wall Street professionals expect either inflation concerns or the minor upturn in short-term interest rates imposed by the Federal Reserve earlier this month to derail the bull market.

``This is an interest-rate driven market, and January was very good for the stock market, with the Dow Jones industrial average up 6 percent,'' says Larry Wachtel, a vice president with investment house Prudential Securities Inc. ``Where do we go from here? Obviously, the January pace cannot be sustained for the entire year. So it is equally obvious that there would have to be some type of correction.''

That modest correction ``is now occurring,'' he says.

But that does not suggest that there will now be a shift toward a bear market, Mr. Wachtel says. He notes that if history is any guide, February will be more of a down market than an up market - but with the bull market resuming its upward momentum in March.

Over the course of the past 44 years, he adds, market indexes have fallen in 24 years during February, compared with 20 years in which market indexes moved upward. By contrast, the market, as measured by the Standard & Poor's 500, moved up 29 times in March, and down 15 times.

``I see more of a consolidation occurring right now than an actual correction,'' says Robert Dickey, a technical analyst with Dain Bosworth Inc., an investment house based in Minneapolis, Minn. ``I continue to be impressed with the resiliency of this market, which, despite advancing for more than three years now, still shows strength.''

Given the length of the bull market, selectivity in picking stocks becomes especially important, Mr. Dickey says. He adds that he favors economically sensitive stocks that should benefit in a period of recovery. Promising sectors include airlines, aluminum, autos, basic industries, chemicals, consumer durables, cyclicals, gold, hospital management firms, paper, and railroads, he says.

Even a slight additional boost in short-term rates - such as another quarter-point hike in the federal funds rate - should not derail the bull market, Dickey says. ``I'm bullish for at least the next three to six months.''

The Federal Funds rate, the interest that commercial banks charge on overnight loans to one another, stands around 3.25 percent. The Fed's move was meant to reassure financial markets about its stand against inflation, yet seems to have made those markets more edgy.

Dickey does not see any financial or political development under way in global commerce that is likely to inhibit or derail the current bull market. That would include continued trade tensions with Japan and a tougher political and military stance by Western industrial nations against the Serbian government, he says.

Not all market watchers are sanguine about the current pace of the economy and the upturn in interest rates, however. James B. Stack, who publishes InvesTech, a market newsletter, says that the current ``complacency'' about stock prices, as well as the recent shift in Federal Reserve Board policy, ``has me doubly worried.''

Mr. Stack predicts that the recent quarter-point hike in the Federal Funds rate will soon be followed by another increase. Based on rate hikes going back to 1954, the second rate hike has usually followed the first hike within one to four months, he says. And the total increase in short-term rates, which takes place over a period between one to five years, is usually 2 percent or more.

Stack urges his clients to move to a more defensive, higher-cash position.

Technically, the market is ``no longer a healthy bull market,'' Stack maintains. Because of Fed interest rate policies, a ``dark cloud'' is forming overhead, he says.