Interest rates are culprit behind market's decline

STAYING AHEAD

April 18, 1994|By JANE BRYANT QUINN | JANE BRYANT QUINN,Washington Post Writers Group

NEW YORK -- What if it's really a bear market? True bears don't claw at stock prices for a couple of months and then slouch away. Every rally is a false one while the dominant downtrend plays itself out, says Richard Russell of La Jolla, Calif., editor of the Dow Theory Letters.

For the past 20 years, Russell's technical analysis kept calling this market a bull trip (with the '87 crash just a one-day disaster). Two weeks ago, however, his data turned down -- forecasting a (( decline in stocks.

How much of a decline, or for how long, no one can guess. Gail Dudak, U.S. market strategist for S. G. Warburg and not currently a bear, thinks this downturn will amount to no more than a 10 percent correction in what is still a rising trend.

The traditional definition of a bear market is a drop in stock prices of 20 percent or more. After its recent wild ride, the Dow Jones industrial average was down about 7 percent at the end of last week, from its January high of 3,978.

What caused the drop? Let me clear the decks of a notion advanced by conspiracy theorists. This is not a plot by the rich to bring President Clinton down. The rich prefer to get richer, not poorer, and a lot of rich speculators have gotten creamed.

And it's not Whitewater or North Korea or health-plan jitters. News events may hit a market for a day or two, or hurt a particular industry's stocks, but they don't turn a bull into a bear.

The real culprit is interest rates.

When business is weak, there's not a lot of demand for money. So the economy's savings -- including the buildup of funds in banks -- pour into the securities markets. Prices for stocks and bonds go up and interest rates go down.

But when business catches fire, as it did last October, the demand for loans goes up. Business borrows to expand production; consumers borrow to buy cars and homes. This stepped-up demand for money pushes interest rates up.

Improved business can -- potentially -- lead to higher inflation, if demand for materials and labor stays strong. Renewed inflation is not now perceptible in the economy. But the leading indicators of inflation risk have been shooting up.

To head off this risk, the Federal Reserve Board has twice raised the discount rate, which is the interest rate banks pay when they borrow money overnight.

When interest rates rise, the value of bonds and bond mutual funds goes down. This came as a shock to some refugees from bank certificates of deposit who believed that bond mutual funds -- especially government bond funds -- were safe. Bond funds still pay a higher current income than CDs, which is why you bought them. But their market value will not increase until interest rates decline again.

Rising interest rates also hurt stock prices. That's because investors always compare the dividends they get from stocks with the interest rate paid by short-term Treasuries or money market funds. For many months, the annualized yield on the stocks in Standard & Poor's 500-stock index has been under 3 percent. When interest rates rise, that yield looks puny. So stock prices fall to whatever level will make current dividend payouts look competitive again.

Rising interest rates will probably slow home and car sales, and slow the business expansion. Inflation will then look less threatening and interest rates should stabilize.

But even at a slower pace, economic growth will be solid and ongoing, in the opinion of Allen Sinai, chief economist for Lehman Brothers. For this reason, he expects a healthy rise in dividends and earnings.

Bond funds won't recover all their losses because, in a rising economy, interest rates won't fall. But stronger earnings will eventually move stocks forward again.

A political note: Stocks often decline in the second year of a president's term. But 40 percent of all the bull markets in this century have also started in a president's second year. So far, individual investors haven't been dumping stocks and mutual funds -- although neither have they been putting a lot of new money in.

You never know what will happen to the stock market next. But history shows that a steady buying program serves long-term investors best.

NEXT TIME: How to invest in a chancy market.

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