When Strength Is Cause for Fear

By TOM PETRUNO

July 1, 1994 12 AM PT

Maybe the best way to explain global financial markets’ dismal first-half performance is like this: There’s a big block party raging in the real economy on Main Street, but Wall Street has been cordoned off from it--indefinitely.

Global stock and bond markets ended the second quarter Thursday with another selloff, as new signs of the economy’s underlying strength reignited fears about higher interest rates and higher inflation.

* The Dow Jones industrial average tumbled 42.09 points to 3,624.96, nearing its 1994 low of 3,593.35, reached April 4. After rallying in late May and early June, the Dow has sunk in recent weeks as interest rates have rebounded and the dollar has tumbled.

For the quarter, the Dow was off 11 points, and year-to-date it is down 129.13 points, or 3.4%. From its peak of 3,978.36 on Jan. 31, the index has lost 8.9%.

* U.S. Treasury bond yields rocketed Thursday, almost back to the 1994 highs reached in May. The 30-year T-bond yield soared to 7.60% from 7.51% on Wednesday and now is just under the May 9 peak of 7.65%. At the start of the year, the yield was 6.35%.

The near-constant upward pressure on interest rates, which began when the Federal Reserve Board began to tighten credit Feb. 4, has produced painful losses for owners of virtually every kind of bond, short- and long-term. Long-term T-bonds suffered a negative total return of 8.6% in the first half, according to a Merrill Lynch index. That means that, even after the interest earned on the bonds, their owners were $86 in the hole for every $1,000 they had invested on Jan. 1.

* Foreign stock and bond markets, most of which produced stellar returns in 1993, generally suffered bigger losses than their U.S. counterparts in the first half. While the U.S. broad stock market index, the Standard & Poor’s 500, dropped 4.8% in price in the first half, German stocks fell 10.6%, and Hong Kong shares tumbled 26.3%.

Wall Street analysts concede that the average American is likely to be baffled by the markets’ response to good economic news this year. The prospect of a continuing U.S. expansion, along with recoveries under way in Europe and Japan, will put more people to work and generate higher profits for companies around the planet.

Moreover, thanks to intense global industrial competition, there are few signs that the recovery will be markedly inflationary--which means that long-term bond yields shouldn’t be rising so dramatically.

But after six months of making excuses for markets, and predicting that stocks’ and bonds’ selloffs would soon end, many analysts are growing wary about guessing where the ultimate bottom may be.

Steven Nagourney, global strategist for Lehman Bros. in New York, says markets may simply have become victims of their own incredible success in 1993. With last year’s global rallies, stock and bond prices reached levels that reflected most or all of the good things that could happen in the near term, Nagourney says.

“Now there’s no value left in markets, but they can’t embrace the idea of (global) growth yet,” he adds. The result is confusion, apprehension and selling, he says.

Some analysts also suggest there has been an inordinate number of disasters striking the markets in rapid succession--from the unwinding of “hedge” fund speculation last winter to shortages in some key commodities in the spring, to the latest crisis of the dollar’s collapse.

“It does seem as though events have been particularly perverse recently,” laments Arnold Kaufman, editor of Standard & Poor’s Outlook stock letter in New York.

Perhaps most frustrating is the breadth of the markets’ losses. People who tried to hide in traditional safe havens such as gold, for example, have ended up losers as well. The only true safety has been in “cash” accounts: The average money market fund earned 1.5% in the first half.

In the bond market especially, some experts now say the best strategy is to just admit that the economy is getting better and that interest rates are going up--which is inherently bad for bonds.

Bonds’ periodic attempts to rally this spring don’t change the basic story, which is that a bear market is in full swing, argues David Jones, economist at bond dealer Aubrey Lanston in New York. When the Fed tightens credit three or more times, as it has this year, “the rule is to sell bonds and get into Treasury bills,” Jones says. “We’re in a bear market’s grip, and it’s not going to let go soon.”

But isn’t there a good case that the stock market will eventually respond more to the economy and less to interest rates? Some investors might argue that’s already happening: The S&P; 500, down 4.4% in the first quarter, eased just 0.3% in the second quarter.

Howard Freedland, editor of the Investment Strategist newsletter in Marina del Rey, agrees that savvy traders can still make money in stocks. But that doesn’t change the fact that a dangerous bear market is here, he contends. “The thing you don’t want to be in a bear market is a hero,” he says.

Markets at Mid-Year: No Place to Hide?

Stocks and bonds closed the second quarter on a down note Thursday. Overall, most investments worldwide were losers in the first half.

Stocks: Dow Ends Near ’94 Low

Dow Jones industrial average, Monday closes except latest

Thursday: 3,624.96

Bonds: Yields Surge Again

Average yields by type of bond

June 30:

20-year muni gen. obligation: 6.09%

1- to 10-year U.S. Treasury: 6.52%

Long-term top-grade corporate: 8.22%

Other Markets: Many Losers, Few Winners