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JAMES FLANIGAN

Economy Heats Up, Market Gets the Chills

January 10, 1988|JAMES FLANIGAN

Holy cow, what now? Why did the stock market take a 140-point nose dive on Friday? And what does the market's decline say about what lies ahead?

Stocks fell and so did bonds, because investors feared that rising interest rates were coming, as figures released early Friday showed the economy to be expanding strongly instead of slowing down in the wake of last October's stock market crash.

As to what lies ahead, that includes a lot of good news--in very important matters--and some bad news, too. If current trends continue, the economy will be quite strong in 1988, with full employment, rising wages and pretty strong consumer spending--including good car sales. But accompanying that will be rising inflation and interest rates and a declining stock market early in the year.

Government statistics showing that unemployment dropped to 5.8% in December was the news that set off the avalanche on Friday. For all intents and purposes, because of the number of people normally between jobs--and because of unfortunate people who are permanently unemployed for lack of skills--that 5.8% means the economy is encountering labor shortages, which in turn means rising wages.

And that raises the specter of higher inflation, something investors haven't had to worry about since 1981.

They started worrying again on Friday, because other statistics showed that consumer spending hadn't slowed down either.

Why should that make stocks fall? Because continued consumer spending will set up a tug of war with government's need for savings to finance the budget deficit and industry's need for capital to expand factories because a lower dollar is boosting U.S. exports.

On Friday, investors added up all those factors, saw higher interest rates ahead, and sold bonds and stocks in a great rush.

How high could interest rates go? Pretty darn high, says David Eisenberg, chief investment strategist of the New York research firm of Sanford C. Bernstein--who has been saying that the economy will remain strong. Eisenberg foresees 30-year government bonds--the bellwether for all long-term interest rates--at 11% by the end of September and up to 11.4% by the end of 1988. If Eisenberg is even in the ballpark, that indicates the highest interest rates since 1984--when the 30-year government bond hit 13.94%.

Weather Has Affect

But one Friday doesn't make a trend. In the coming week look for confirmation from the national retail sales figure coming out on Thursday and the trade figures on Friday. Then look for the statistics on factory utilization, which will probably say that U.S. factories are operating at 81% to 82%. That actually means no spare capacity; above 82% industry becomes strained, like a car that shakes at 70 m.p.h. even though the speedometer goes up to 120. When demand strains capacity, either prices go up or the factory has to be expanded.

OK, let's put it all in perspective. A strong economy means low unemployment and people with paychecks. Good business, in short--even though inflation may hit 6% and interest rates rise.

High interest rates, at least initially, make stocks a less attractive investment; a government-backed bond paying 10% or more beats returns on common stocks. Also, of course, rising interest rates affect the economy, slowing housing markets but rewarding savers. Markets usually gyrate when the economy shifts like that.

But why did the markets suddenly sell off on Friday? Many reasons, including a snow storm in New York that sent stock traders and investment managers home early. With fewer traders, there were fewer potential buyers. And with uncertainty because of the economic news--plus a presidential study commission about to make recommendations on stock market regulation--prudent investment managers didn't want to get caught holding stock over the weekend as they had before the crash of Monday, Oct. 19.

What will happen this week? Who knows? There can be rallies--as there have been since the first of the year. But we're in a bear market--meaning the trend is down--as investors discovered anew last Friday.

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