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Stocks take interest-rate uptick in stride

The stock market last week showed a degree of poise, weathering another (not unexpected) rise in the prime interest rate. That may have been an indication of the underlying strength of the market at its current level - and of investors' faith that the economy can only improve from this point. The Dow Jones industrial average closed Friday at 1,132.40, up 1.33 points for the week.

(Much of the market's strength late in the week could be traced to IBM and General Motors, two of the largest components of the Dow.)

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A summer rally, many analysts contend, will probably occur, because of (a) the oversold conditions that have beset the market since early spring, (b) the big cash positions that many institutions are maintaining, and (c) the fact that this far into the election cycle the Reagan administration will go to great pains to avoid disheartening economic news.

But don't expect too much from the stock market in the short run, some money managers warn. Their advice: Use downturns in the market to buy - but buy only high-quality stocks. If you are investing rather than trading, consider the merits of 13 percent-plus government bonds; it's pretty hard for stocks to beat that kind of return and safety.

Like many other Wall Street-watchers, Robert J. Wibbelsman, investment strategist for Kayne, Anderson & Co. brokerage of Century City, Calif., believes a summer/fall rally is probable. But he is not impressed by the strength of the market from an investment point of view.

Mr. Wibbelsman notes that the stock market's ''advance-decline line'' has angled downward since last summer. Although the Dow appears to have held itself for the most part above the 1,100 mark, Wibbelsman does not expect a great upturn.

''I view rallies with some suspicion,'' he admits. ''We are still in a bear market until proven otherwise.''

That ''otherwise,'' he says, could be either a washout below the 1,050 level on the Dow or a dramatic rally akin to the one that began in August of 1982. Meanwhile, if you are buying stocks, says Wibbelsman, ''buy the market leaders.'' If a money manager or an individual investor is planning to really achieve good, safe return, he says, ''then you've got to go back to bonds - they're a lot easier way to go, really a safe haven for your long-term investment.''

Yet one could just as easily make the argument that if the economy eventually settles into a pattern of moderate growth, modest interest rates, and low inflation, stocks - not bonds - should bring in the better return over the long run. This is because if interest rates decline, the bond-yield curve will begin to flatten and the total return that can be realized from high-quality stocks should look more competitive.

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The Dreyfus Group mutual fund family is one big institutional investor that used the drop in the Dow Jones industrial average to buy good-quality stocks and move into a fully invested position. Like Mr. Wibbelsman, Dreyfus's research director, Monte Gordon, does not see an astounding stock rally in the works. He figures the range for the Dow will be between 1,050 and 1,200.

''That pattern will continue as long as the economy is paralyzed into place with higher interest rates,'' Mr. Gordon says. ''I don't see any real sustained rally.''

But he contends that time is on the side of investors who are looking for the economy and interest rates to moderate. The big surprises of late have been the persistent strength of the economy, but this cannot continue indefinitely, he says. For both the stocks and bonds, he says, ''the keystone in the arch is interest rates.''

At present, Gordon says, many good stocks are undervalued: When interest rates drop, the value of those stocks will be apparent. That calls for resolve - and faith in anti-inflation policies.

Although much has been said about the connection between interest rates and the fortunes of the stock and bond markets, a look at the connection between inflation and interest rates shows why it is important in the long run for inflation to stay low.

Traditionally, you could expect bonds to return 2 to 3 percent above the rate of inflation. In the mid-'60s, when inflation was running at about 4 percent, interest rates on bonds averaged 6 or 7 percent. Anything more was excessive return, considering the unparalleled safety factor of a note issued by the US Treasury. Anything less would not really make the investment worthwhile, since inflation would be eating away at your investment.

Then came the high inflation of the 1970s.

At first, unable to believe that the spurt in inflation was anything other than a fluke, bond investors continued to accept those 6 to 7 percent interest rates. But as inflation mounted throughout the mid- to late '70s, investors began to lose heart. That caused interest rates to rise, and they hit their all time high of nearly 20 percent in 1980-81.

Then the Federal Reserve's disinflationary policy took hold. Inflation has been knocked down to between 4 and 6 percent a year. But investors wonder: Will it stay there? Or will it go back up to 10 percent or more?

Because they are not sure of the answer, bond buyers have been reluctant to lock themselves into long-term investments - unless those are at exceptionally high interest rates.

In a recent commentary by the authoritative Moody's Bond Survey noted that the low measure of inflation (registered at 2.8 percent in the second-quarter GNPestimate) at a time of strong economic expansion ''is reason for celebration and not for despair in the credit markets.''

If that attitude takes hold, then the 2 to 3 percent premium over inflation could bring interest rates back down to 6 to 8 percent.

And that, most investors and borrowers agree, would really be cause for celebration.

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