Interest rates fuel Dow's southward trip

Only a few months ago, some stock market analysts were talking about the Dow Jones Industrial Average at 20,000 or higher - and calling the financial markets the perfect place for Social Security investments.

Everyone from grandmothers to teenagers in high school were jumping on the investment bandwagon.

Now, after a bad start to the year, the Dow Jones Industrial Average - and most of the rest of the market as well - is heading south. Since Jan. 14, the Dow is off 1,862 points, or about 16 percent There is now talk the Dow will head back to the 9,000 level - the same place it was this time last year. What's happened to the double-digit increases?

In a few words: interest rates.

The Federal Reserve meets on March 21 and the chairman of the central bank, Alan Greenspan has already said he expects interest rates will rise - and rise and rise - until the economy and Wall Street - begin to slow down. So far, Wall Street - except for the high technology stocks - has paid attention.

"The markets are fearing how far the Fed will have to go," says Bruce Steinberg, chief economist for Merrill Lynch & Co.

Most economists now expect the Fed will raise interest rates at least two more times this year. This would be a total of six interest rate hikes since June 30. The last time the stock market had a down year, in 1994, the Fed raised interest rates six times. However, some economists are now predicting the Fed will have to hike rates three or four more times before the economy slows down. This would move the prime interest rate - the rate banks charge their best corporate customers - to 9-3/4 percent - the highest interest rates since 1990.

Behind the rising interest rates is one of the most robust economies in years. On Friday, the Commerce Department revised the fourth-quarter gross domestic product (GDP) from a 5.8 percent annual rate to 6.9 percent. Although economists expect the GDP to slow to 4-1/2 percent annual rate in the current quarter, there is not a lot of evidence of this. For example, car sales in February indicate Americans are still writing checks with abandon. And, despite higher mortgage rates, new homes sales were strong in the past two months.

Tomorrow, the University of Michigan will release its latest reading of consumer confidence. Despite the stock market's decline, Richard Curtin, director of the surveys says he doesn't expect much decline.

"Consumers are not going to sense a bear market because of several down days," he says. "The idea that consumers recalculate their wealth at the end of each evening and shift their spending sounds naive," he says.

Instead, Curtin says consumers look at the real economy. On Friday, the government will release yet another indication of how strong the economy is: the February unemployment rate. "The fear is that it will drop to 3.9 percent," says Sam Stovall, a senior strategist at Standard & Poor's. "If the data is stronger than expected, it will provide additional fuel to raise interest rates."

So far, the higher interest rates have not done much to slow the economy. Take the housing market. Last week, the government reported existing home sales declined about 10 percent. But much of that is because of a lack of sellers, not buyers. In the meantime, new home permits were very strong in January.

The strength is surprising since mortgage rates have risen from 6-3/4 percent to about 8.3 percent. Dave Seiders, chief economist for the National Association of Home Builders, is anticipating rates will rise to 8.5 percent by midyear.

Instead, the prospect of rising interest rates has been felt the most on Wall Street - one of Greenspan's main targets. In his most recent congressional testimony, the Fed chairman warned that the "wealth effect" from rising stock prices was driving the economy. Until stock market gains flattened, he indicated, he would continue to raise interest rates.

"What Greenspan wants is for stock market investors to be less confident than they have been," says Robert MacIntosh, a portfolio manager for Eaton Vance, a Boston mutual fund.

Although the Dow average has followed this script, technology stocks continue to rise. Last week, for example, while the Dow average was faltering, the Nasdaq average, which includes many Internet companies, hit a new high - as did the Dow Jones Internet Index.

Money managers said a lot of this new investment came from individuals who are now frustrated that their investments in profitable companies are declining while the stocks of Internet companies, almost all of which are losing money, are rising. In the week ending last Wednesday, $1.6 billion went into new technology funds while consumers took money out of funds that mirror the S&P 500 index.

Mr. Steinberg notes that without the technology investments, the market is down 19 percent from its highs. "The wealth effects are starting to unwind and I think the Fed will be happy to see that," he says. But he wonders if Wall Street investors are now turning overly bearish. "The market is looking for a pretty bad outcome here," he says.

Instead, Steinberg, like many other economists, is expecting the economy to just ease back to a more sustainable rate. After the Fed raises interest rates two or three times, he expects economic growth will moderate to a 3 to 3.5 percent annual rate.

If the economy moderates and interest rates remain high, it might just result in a period of mediocre or negative returns in the stock market. "We're due for a down year in the market," says Mr. MacIntosh. "It looks like we're starting off that way."

(c) Copyright 2000. The Christian Science Publishing Society