Effort to leash the deficit seen as unleashing the stock market

Political brinkmanship over the national debt appears to be important in spurring the stock market to record highs. True, one might be able to find other reasons for bullishness on Wall Street: modest interest rates, low inflation, the likelihood the Federal Reserve will try to boost business activity going into 1986. Even the Reagan-Gorbachev summit could be contributing to optimism.

But several knowledgeable market analysts say the Gramm-Rudman budget-balancing bill -- no matter its constitutional or economic shortcomings, or whether it actually passes -- indicates Congress is finally serious about taming the federal deficit.

``The increased talk about Gramm-Rudman is an important stimulus to the bond and stock markets,'' says William C. Fletcher, chief investment officer of Independence Investment Associates of Boston, a money-management subsidiary of John Hancock Insurance.

Although he is dubious about the merits of the Gramm-Rudman approach, Mr. Fletcher concedes that because of it ``there is a lot of enthusiasm about a possible breakthrough on the deficit.''

John D. Connolly, chairman of the investment policy committee at the Dean Witter Reynolds securities firm, sees a scenario where ``the economy gets stronger and the government begins backing out [of credit markets].'' That, in turn, would help interest rates moderate, bond prices increase, and high-quality stocks do well.

Although he notes that, having been postponed twice, Gramm-Rudman may be dragged down by inertia, Mr. Connolly still feels that it indicates ``profound changes are under way in this country's economic policies.''

Over the long run, Paul Wachtel, professor of economics at New York University, agrees that ``the hullabaloo about Gramm-Rudman does imply that Congress is taking the notion of deficit reduction more seriously.'' He, too, questions the wisdom of the current approach. In the end, Dr. Wachtel believes, ``something correct will be done'' about the deficit.

As it was, the United States Treasury was on the sidelines briefly last week because of the wrangling in Washington, and that may have been a factor in the big bond and stock market rallies. The Dow Jones industrial average gained 30.73 points, closing Friday at 1,435.09.

(Several analysts watching the action last week noted that the bullish psychology was also being boosted by primary government bond dealers, who benefit greatly when their main product is in demand. If true, this might indicate that the stock and bond market rallies of last week were of a more technical than fundamental nature.)

Congress postponed the Gramm-Rudman debate until Dec. 6 by passing a temporary increase in the debt ceiling, and the onslaught of Treasury refinancing in the next two weeks may now dampen the financial markets.

Already on Friday, the morning after the debt ceiling was extended, open-market interest rates rose as the Treasury announced plans to sell a total of $61 billion in new debt securities over the next two weeks.

Profit- and loss-taking for tax purposes might also cause the market to cool off between now and Dec. 31.

Nevertheless, Wall Street appears to be buying the idea that in one form or another government borrowing is going to be reined in. To that can be added a relatively salutary outlook for inflation (despite an upturn in the producer price index last week) and for the economy (despite a downturn in retail sales, also last week).

Professor Wachtel at NYU, who has studied the effect of expectations on the financial markets, sees monetary growth, lower interest rates, the gradual erosion of inflation, and the general ``availability of liquidity'' as long-term factors contributing to bullishness.

There is still fuel for the fire, too. In 1979, institutional investors had $15.5 billion under management. In 1984, it was $140 billion. Roughly $93 billion is in money-market funds, bond funds, and cash reserves and could migrate to the stock market as interest rates decline.

Even so, the euphoria on Wall Street has not been so great that it portends a market top, says Newton Zinder, chief technical analyst for E. F. Hutton in New York: ``People are still cautious.''

Mr. Zinder expects the market to slow down somewhat now -- but not too much or too long. The bond market will remain fairly strong, he says, and that will carry over to interest-sensitive stocks such as banks, insurance companies, utilities, airlines, and retailers. He notes that although the Dow is hitting records day after day, other indexes, in particular Value Line and the NASDAQ, are still below the levels they reached last summer.

While Zinder warns against buying stocks in these areas simply because they are low (there could be good, fundamental reasons they are low), he nonetheless sees this as further evidence that the market is not overbought.

One should never expect across-the-board agreement on the outlook for financial markets, of course. A caution flag is raised, for instance, by Burton M. Siegel, chief investment officer of Drexel Burnham Lambert. In a recent report, Mr. Siegel noted that the rise in stock prices in 1985 has occurred even though corporate profits have not grown.

Current stock prices already incorporate expected earnings gains in 1986, Siegel says, and he believes that ``consensus 1986 earnings expectations for many economically sensitive stocks are too high.'' This is a ``source of stock price vulnerability,'' he adds.

Most economists, however, consider the lackluster days of the economy as having occurred earlier this fall. The Fed appears eager to forestall a recession, and so ahead should be economic growth. But how long the Fed can keep priming the economy is an open question. Siegel figures the expansion cannot be maintained much beyond early 1987. Chart: Interest Rates. *Yields; Source: Bank of Boston.

Percent Prime rate 9.50 Discount rate 7.50 Federal funds 8.63 3-mo. Treasury bills 7.34 6-mo. Treasury bills 7.36 7-yr. Treasury notes 9.71* 30-yr. Treasury bonds 10.13*