FALLOUT FROM RISING RATES : The Fed and the Markets: What Investors Need to Know

Friday’s 96.24-point plunge in the Dow Jones industrials--a reaction to the Federal Reserve’s first official interest rate hike since 1989--raised concerns about the bull market’s future. The Dow’s plunge was its largest one-day drop in more than two years.

What should you make of this move? And should it change your investment plans? Here are answers to questions stock and bond investors may have in the wake of the Fed’s action.

Question: Why did the stock market react so badly, when the Fed’s move had been widely expected?

Answer: That question dogged many pros, who admit that this was perhaps the most anticipated Fed credit-tightening in history. Just last Monday, Fed Chairman Alan Greenspan warned that the strengthening economy would inevitably produce somewhat higher short-term interest rates.

In theory, the Fed’s move to raise a key short-term interest rate, the federal funds rate, from 3.0% to 3.25% should have been built into stock prices; the actual announcement on Friday should have prompted investor yawns.

The problem may have been one of simple complacency: Whenever too many investors assume the market will act a certain way, it often does the opposite.

Also, because stocks had surged to record highs earlier last week--pulling in many short-term speculators--those traders were poised to exit at the first hint of bad news.

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Q: But historically, haven’t stocks dropped whenever interest rates have risen?

A: That is one of the market’s biggest myths. The truth is, rising rates generally don’t end bull markets--not in the initial stages of the rate rise, anyway.

Typically, as the economy begins to gain steam after a recession, short-term rates rise as consumers and businesses borrow more.

But instead of focusing on the turn in interest rates, stock investors usually focus more on the surge in corporate earnings that is a byproduct of a stronger economy.

The result is that stock prices and short-term rates often advance together as the economy revs up. That occurred in 1983, for example: Three-month Treasury bill yields rose from 8% to 9% with the burgeoning economy, yet the Standard & Poor’s 500-stock index jumped 17% that year.

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Q: How much of a rate rise will it take to kill the bull market?

A: There is no set increase that anyone can point to in advance and say, “This is it.” It’s unclear how high short-term rates would have to rise, for example, before individual investors would decide that they’re better off in a money market fund than in stocks, thus reducing the crucial flow of fresh cash into the market.

Still, many experts believe that short rates will have to rise significantly more than the quarter-point increase the Fed has dictated before money funds provide competition for stocks. Money funds’ average yield, now 2.72%, could rise to 3% with the Fed move. But that would still be rather paltry.

Some Wall Street analysts, in forecasting bear markets, look to the frequency of Fed rate hikes as a guide rather than how much rates rise. One classic rule is “three jumps and a stumble”: Historically, the stock market often has peaked only after the Fed raises rates three successive times.

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Q: If the economy is OK, shouldn’t stock prices quickly recover?

A: In theory, yes. Many investors feel that little has changed, despite the Fed move. “The economic recovery is real, and corporate profits should show a very nice increase this year,” says Larry Auriana, co-manager of the Kaufmann stock fund in New York.

And of course, investors large and small have been conditioned since the 1987 market crash to buy on any dramatic declines--because prices have rebounded every time.

Even now, stock mutual funds have large cash hoards waiting to be invested; the funds’ cash holdings equaled nearly $60 billion, or 8.5% of total assets, as 1994 began. What’s more, stock funds now have a tremendous regular source of incoming cash that many didn’t have in the ‘80s: money from 401(k) retirement plans.

But again, the problem here may be too much complacency: Investors expect the market to resurge. If it doesn’t come back immediately this morning, potential buyers could continue to wait on the sidelines--allowing prices to fall further, which in turn could increase investors’ cautiousness, setting off an even deeper slide.

On Sunday, small investors’ complacency was evident in a report from Fidelity Investments, the nation’s largest mutual fund company: Despite Friday’s market plunge, Fidelity said it got relatively few weekend calls to its toll-free information numbers, from buyers or sellers.

“It’s been a very light weekend,” said spokeswoman Tracey Gordon. Of course, it’s heartening that investors weren’t calling to sell--but neither were they buying.

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Q: What is the worst-case scenar io for stocks?

A: The Fed’s rate boost could be enough to trigger the first meaningful “correction” in this 39-month-old bull market.

Typically as bull markets advance, stocks experience periodic selloffs that clip 5% to 10% from the Dow index, the S&P; 500 and other indexes as investors take profits. In this bull run, however, the market as a whole has yet to give up more than 5% of its advance (though many individual stocks certainly have done so).

Precisely because this bull market has held up for so long, the Fed’s move makes it vulnerable to a true correction, many experts say. “When the market gets to be like a coiled spring, something like this can trigger its release,” says Ralph Wanger, who heads the $4-billion Acorn Funds in Chicago.

If the Dow were to drop 10% from its all-time high of 3,978.36 last Monday, it would fall another 300 points after Friday’s 96.24-point, 2.4% decline. That would put the index at about 3,580, back to where it was last September.

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Q: Wouldn’t that kind of slide be a definite buying opportunity?

A: Assuming the economy’s expansion remains on track, the answer is yes, most analysts say. Though stock prices are historically high now, relative to earnings and dividends, a growing economy will boost earnings and thus dividends--which will make stocks appear much cheaper over time.

The risk is that the economy proves much more vulnerable than expected to the relatively small rate increase engineered by the Fed last week. If business activity were to slump again by spring, the stock market could be in trouble.

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Q: Which stocks or stock groups could fare best when the market rebounds?

A: If you believe that the economy will continue to grow, many analysts say the stocks to own are the same market stars of 1993 and the first month of this year: industrial issues such as autos, steel, machinery and other groups that should see greater demand for their products as consumers and businesses spend more.

Analysts note that big-name industrial issues in particular could benefit if foreign investors increase their purchases of U.S. stocks. And foreigners may soon have a very good reason to boost their buying here: Higher interest rates in America have a side effect of bolstering the dollar’s value.

Indeed, the dollar zoomed to a 2 1/2-year high against the German mark on Friday after the Fed rate hike. When the dollar rises in value, it automatically boosts the value of U.S. stocks owned by foreigners--giving them more incentive to own U.S. securities.

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Q: What if I own bonds? Is it time to sell, if rates are going up?

A: Generally speaking, it becomes much more difficult to make money in bonds as rates rise, because higher market rates erode the value of existing bonds.

Ironically, the investors hurt worst in bonds in recent weeks have been owners of supposedly safer shorter-term issues. Anticipating the Fed’s rate hike, the market has pushed up short rates by more than a quarter point, slicing into shorter bonds’ values.

Long-term yields, in contrast, haven’t risen nearly as much. And some experts say long-term yields could even drop this spring, despite higher short rates, if investors believe that the Fed’s efforts to slow the economy will ultimately keep inflation in check. Long-term yields respond more to inflation concerns than anything else.

For bond investors who need interest income, the best strategy remains the simplest: Split your investment among short-term, intermediate-term and long-term bonds or bond funds. That will give you maximum flexibility, however interest rates move from here.

How Rates Have Surged

The Federal Reserve officially raised short-term interest rates on Friday, but the market has been pushing Treasury security yields up for weeks in anticipation.

Jan. 21 Friday Treasury issue yield yield Change 3-month 3.01% 3.28% +0.27 pts. 6-month 3.21% 3.47% +0.26 pts. 1-year 3.48% 3.83% +0.35 pts. 3-year 4.37% 4.65% +0.28 pts. 5-year 5.04% 5.30% +0.26 pts. 10-year 5.70% 5.88% +0.18 pts. 30-year 6.28% 6.36% +0.08 pts.

Los Angeles Times