Inflation, higher rates could dampen market

January 02, 1994|By Ian Johnson | Ian Johnson,New York Bureau

NEW YORK -- About this time last year, many market strategists were casting worried glances at their computer screens, distrustfully eyeing overvalued stocks and muttering that a market correction was due sooner or later.

A year later, as forecasters try to figure out what will happen in 1994, they are confronted with almost the same situation.

The stock market has never been more expensive, but investors continue to buy U.S. stocks for want of a better alternative.

"We're still in the sweet spot of the cycle. Interest rates are low, growth is picking up and the market is poised for higher growth. Right now there's nothing to cause a change in this outlook," said Mary Jane Matts, director of research for Cleveland-based Society Asset Management Inc.

While the market did not perform spectacularly in 1993, it gave historically average returns. The Dow Jones industrial average of 30 leading stocks closed Friday at 3,754.09, up about 14 percent on the year, while the more representative S&P 500 closed Friday at 466.45, up about slightly more than 7 percent on the year.

A sizable number of Wall Street gurus, however, warn that the pendulum will swing back this year, bringing down the 38-month stock market rally, a record number of months without a 10 percent downturn.

"This year will be tougher than last year. Last year you had euphoria over a new president and other psychological advantages. This year will see growing inflation and higher interest rates," said David Shulman, chief equity strategist at Salomon Bros. Inc.

The difference between the two views can be boiled down to different outlooks on inflation, the bugaboo of strong financial markets.

"The trend over the past decade has been disinflation, not

inflation. There's little evidence that this trend has been supplanted by a new one of inflation," said Richard Rippe, chief economist of Prudential Securities Inc.

Mr. Rippe said inflation will stay low thanks to weak overseas economies and low prices for natural resources, such as oil. In addition, companies in the United States continue to find ways to cut prices and lay off workers -- hardly the scenario for large wage or price jumps that would cause inflation, he said.

As long as inflation stays low, the Federal Reserve will not increase interest rates, Mr. Rippe said. A move by the Fed to increase rates would hurt stocks by making bank deposits and certificates of deposit more appealing to investors than they are currently. Presumably, many investors would sell their stocks for low-risk CDs, setting off a stock market downturn.

Although rampant inflation may not be in anyone's cards, many market observers do see the strengthening economy pushing up inflation enough for the Fed to act. Richard Fontaine, of Richard Fontaine Associates Inc. of Baltimore, said commodity prices are creeping upward as is the number of factories operating at high capacity -- traditional indicators of rising inflation.

"People who are saying that inflation is dead are telling yesterday's news," Mr. Fontaine said. "The easy money is behind us. The coming year will be tougher."

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