The big stock blowout: investors appear uneasy on '85 outlook

Last week was one of those rare weeks of high drama on Wall Street - the kind that makes many money managers wish they had raised more cash early in the year. Not only did the week see a sudden turnabout in administration policy, with the announced pullout of the Marines from Lebanon, and the passing of Soviet Premier Yuri Andropov, but it brought three days of economic testimony on Capitol Hill that sent many investors scurrying for their sell buttons.

The drama unfolded in at least two parts. First came the realization that in an election year Congress is not apt to take any very daring action to reduce the deficit. With budget deficits running close to the $200 billion level in the second year of an economic expansion, a year when business loan demand normally kicks in, the prospect of higher interest rates was too real to ignore.

Moreover, the 1985 budget year just starting to be discussed would take place during the third year of recovery. With interest rates going even higher because of inaction on the deficit, investors could not be sure how much longer the expansion would continue.

Then entered the second factor, the testimony of both Federal Reserve Board chairman Paul Volcker and Treasury Secretary Donald Regan that another recession could indeed be on the horizon if the deficits weren't dealt with.

At the end of trading on Wednesday, the market had skidded 130 points from its Jan. 6 high of 1,286. In further testimony Thursday, Mr. Volcker said he thought the market had overreacted to his comments. Basically, he said, the economic outlook was very bright.

Whether from this comment or not, the market ended the week on a strong note Friday, rebounding 7.96 points on the Dow. The Dow Jones industrial averaged closed Friday at 1,160.70, down 36.33 points for the week. Friday was also the day on which Mr. Andropov's death was announced.

Since August of 1982, the market as measured by the Dow had gone up more than 50 percent without having a major ''correction.'' According to market historians , the first leg of a bull market should retrace at least one-third of its upward move before starting the second up-leg. Even with this decline, the drop hasn't been that severe. Measured on an earnings yield basis (the inverse of the price-earnings ratio), the stock market had gotten out of line with fixed-income yields. In fact, some of the exuberance over stocks earlier in 1983 had rested upon a conviction that interest rates would continue to decline. Instead, they remain, when measured on a real, or inflation-adjusted basis, at record high levels. As they have increased somewhat recently, it was clear that stocks had to have some adjustment before they could move higher.

The newest concern to hit investors is that foreigners, disturbed at the lack of progress by the US in getting its deficit down, will begin to withdraw from the US dollar - this despite the high interest rates being offered. The high exchange rate of the dollar against other major currencies has acted to put a damper on US exports, just as it has made travel abroad cheaper for Americans and the import of goods from abroad cheaper.

This may result in the US trade deficit going as high as $100 billion this year, an outlook that may begin to weaken the dollar. If funds are withdrawn from US markets, this in turn would lead to higher US interest rates. Mr. Volcker touched on one aspect of this when he said, ''. . . we simply can't afford to become addicted to drawing on increasing amounts of foreign savings to help finance our domestic economy.''

Has the market seen the bottom for now? Theory has it that there must be a selling climax before a market can turn. That climax could have come on Thursday, but only the time will tell. The same institutions that have been raising cash because of the above fears are not apt to come rushing back quite yet. On the other hand, the decline has already created some good buying opportunities in high-grade, big-capitalization stocks.

A year ago it was assumed that 1984, a presidential election year, would be a good year for stocks. Such years usually are. Then it was assumed that at least the first half of the year would be good, but that interest rates would have to decline somewhat to fuel an advance lasting all year.

The present decline gives the market some room to go up again, once it gets started. But by spring the institutional investor is apt to be looking at 1985, trying to figure out whether the steps to be taken to deal with the deficit then by a new Congress will put a halt to the present business cycle after only two years.