There's Plenty Of Snort In The Old Bull

For three years now, the U.S. bond and stock markets have lived a blissful, prosperous life together. As interest rates fell, bond prices and stocks marched arm in arm into ever higher territory. And this blessed union spawned hundreds of billions of dollars in profits for millions of investors.

Stocks and bonds are still locked in an embrace. But now they're falling together. The change in direction came on Feb. 4, when the Federal Reserve hiked the federal funds rate by a quarter-point, to 3.25% from 3%. In the four weeks thereafter, the 30-year U.S. Treasury bond dropped about 6% in price, forcing the yield up by nearly half a percentage point. And by Mar. 2, the Dow had tumbled 136 points, to 3832, or 3.5%.

That's not much of a pullback, but trading has been violent and choppy. The market's performance has been punctuated by several single-day plunges of 40 or more points, including a 96-point loss the day of the rate hike. The put-to-call ratio, a closely watched measure of investor sentiment, has been in record-high territory for several weeks, indicating that investors are betting on further declines in stocks. And some market commentators are drafting an obituary for the 1990s bull market.

The report of the bull market's death is premature. The economy is stronger, corporations are leaner and meaner, and plump profits are coming down to the bottom line. "It would be extraordinarily unusual for an equity bull market to end when inflation is low and profit growth is getting better and better," says Abby Joseph Cohen, who co-chairs the investment policy committee at Goldman, Sachs & Co. In response to the Fed's rate hike, Cohen urged Goldman clients to take some profits in bonds and invest them in stocks.

History is on the side of the bulls. Investment strategist Peter J. Canelo of NatWest Securities Corp. notes that stocks usually survive and even thrive after the Fed's first tightening. Indeed, seven of the last eight times the Fed pushed rates up from their cyclical lows, the stock market was higher three months, six months, and one year later (table). That shouldn't be surprising, since the reason for the rate hike is that the economy is strong--which of course is also good for stocks.

SUDDEN STRIKE. What is surprising to stock market investors--and surely to Fed Chairman Alan Greenspan--is the violent reaction of the long-term bond market to the short-term rate hike. The whole premise of the rate hike, Fed observers reasoned, was to make a preemptive strike against yet unseen inflation, and that should not have sent bond prices tumbling.

But market analyst Suresh L. Bhirud of Bhirud Associates Inc. suspects bonds are bombing for other reasons. He argues that financial institutions panicked and tried to pare down their highly leveraged portfolios. "People think all the speculation is in the stock market, but it's really in bonds, currencies, and derivatives," he says. Indeed, a financial institution can buy $100 million worth of bonds with a few million dollars down. The sell-off in U.S. bonds is intertwined with the foreign bond markets as well. As traders lose in one market, they dump other holdings to raise cash, which, of course, can result in further losses. Bhirud believes the selling will soon run its course, bond prices will stabilize, and stocks will climb anew.

If the selling doesn't stop--and if rates continue to rocket--it's hard to see how the stock market can rally. "The market can handle the disappointment of failed mergers or a federal crackdown on tobacco companies," says veteran market analyst William M. LeFevre of Ehren-krantz King Nussbaum Inc. "But it can't handle runaway interest rates."

But the current level of long-term rates doesn't change the bulls' outlook. Melissa R. Brown, director of quantitative research at Prudential Securities Inc., thinks 1994 earnings will be so strong that rates will have to go up another percentage point to damage the stock market. "Stocks are cheap relative to earnings," she says. Nor do stocks have any less appeal to Goldman's Cohen. She says they are still 16% undervalued based on this year's earnings.

The bulls are also counting on the public's appetite for equity mutual funds to continue apace. So far, there has been no noticeable loss of enthusiasm. Robert Adler, whose AMG Data Services tracks mutual-fund money flows, says cash flow into equity funds slowed to $1.9 billion in the week ending Feb. 23, down from an average of $3 billion during the previous three weeks. But he also notes that $1.9 billion came in during a four-day holiday week and is still much higher than a year ago.

In recent years, investors have learned that market jitters usually create buying opportunities, and each setback in stocks eventually draws more money in from the sidelines. Chances are that in a few months, the February flop will look a lot like an opportunity.

      Federal Reserve             Change in S&P 500
      raises interest rates
                     3 mos. after:   6 mos. after: 1 year after:
      MAR. 1971           0.1%         10.7%           8.1%
      FEB. 1972           2.3           5.5            8.5
      FEB. 1976           0.5           2.6            0.3
      JAN. 1977          -4.6          -3.5          -13.1
      JULY 1980           8.7          11.0            7.8
      FEB. 1983          11.8          10.6            7.1
      OCT. 1986          11.4          21.9            3.2*
      MAR. 1988           5.6*          5.0*          13.9*
      AVERAGE             4.5           8.0            4.5
      *Based on month-end prices. Other returns based on average monthly data
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