Investors and analysts nervously awoke to 1985.
Much of the economic news was good. Interest rates were falling, moderate inflation was continuing and the economy seemed to be sailing along at a sustainable growth rate. But caution remained the watchword on Wall Street.
The bad news of the recent past -- rampant inflation, raging interest rates, back-to-back recessions -- had not receded enough to give investors the confidence they once had.
Even though the economic cataclysms that legions of doomsayers predicted for 1984 did not occur, the huge federal deficit, the inability of many important industries to shake off recession and the inscrutably strong dollar are ever-present enough to convince many, if not most, investors that the world as they know it today may be the financial equivalent of the hurricane's eye.
Last year, on balance, was a reasonable year for financial markets. But it was not as beguilingly calm as the hurricane's eye. Indeed, the volatility that characterized both the stock market and the bond put off investors large and small. The continuing tendency of stock and bond prices to react sharply and unpredictably -- both on any given trading day as well as over longer periods -- increases the risk of investing.
An increasing number of investors are becoming more concerned with protecting themselves against losses rather than seeking gains that come from taking risks, according to James Balog, executive vice president of the brokerage firm Drexel Burnham Lambert Inc.
Votalilty is the culprit, Balog said. Prices still can move as much in a day or a week as they once did in a year or a generation.
Last year, for example, interest rates ended the year about a 0.5 percentage point lower than they started. The Dow Jones Industrial Average, probably the most closely watched stock market barometer, ended about 2.5 percent lower than at the start.
Taken alone, the two snapshots taken on Dec. 31, 1983, and Dec. 31, 1984, would suggest a reasonably stable year. But the snapshots conceal wide swings in stock prices and interest rates.
Stocks sagged for the first half of the year, rose sharply in August, dipped in October, recovered in November, stumbled in early December and bounced back near year end.
Interest rates exploded in the spring and early summer, then began an equally swift decline last autumn.
Only last Thursday, for example, the Dow Jones average climbed 16 points -- more than 1 percent -- in two hours on the news that Federal Reserve Board Chairman Paul A. Volcker, speaking to a business luncheon at The Washington Post, was marginally more positive that inflation is under control.
Henry Kaufman, the well-known Salomon Brothers economist whose statements often move markets as abruptly as Volcker's, said he anticipates another volatile year in 1985.
This year may be characterized by the longed-for stable economic growth and moderate inflation that was the hallmark of the 1960s, but investors who yearn for the stable financial markets of that era should not get their hopes up. "The volatility is nowhere near going away," said Kaufman.
Volatility makes investment strategies based on economic fundamentals increasingly worthless. Since interest rates themselves are one of the economic fundamentals, the market volatility strikes hard at forecasts themselves. "It is more difficult to lay down an outlook than ever before," said William V. Sullivan Jr., vice president and chief money market economist for the securities firm Dean Witter Reynolds. "There are many conflicting forces at work. It's reflected in the sharp swings in the market."
In recent years, financial markets have spawned numerous new "products" -- financial futures, interest rates futures, index futures and options -- whose major feature is to reduce the risk of loss from those swings.
Investors have become so obsessed with "protecting themselves against loss that they have eliminated the upside potential of their investments," said Drexel Burnham's Balog.
"Institutions such as pension funds and insurance companies are tending to be conservative," according to Jerry Hinkle, the chief trader for the brokerage firm Sanford C. Bernstein & Co, a firm that deals exclusively with institutions.
Because long-term interest rates are high, even if down from their summer peaks, institutional investors such as pension funds, can lock in returns that satisfy their needs and not worry that they might be forsaking even higher yields in the process, said Robert B. Platt, manager of fixed income research at the investment banking firm Morgan Stanley & Co. Inc.
But Richard McCabe, the chief investment strategist for Merrill Lynch, Pierce, Fenner & Smith, said interest in the stock market will be rekindled in 1985 and that the Dow Jones average, which started the year about 1200, will climb to 1400 or 1500 by year's end.
He said that late 1983 and 1984 were "corrective" periods in which some of the excesses of the 1982 bull market were wrung out. At the end of 1983 investor expectations were high, and when performance did not match those expectations individuals and bigger investors began selling stock. Now, expectations are far lower and when investors recognize that stocks are doing better than perceived they will begin buying again.
The large number of corporations buying back their own stock and the heavy load of either management buyouts or corporate mergers is an indication that at least corporations themselves perceive their stocks as underpriced.
Kaufman of Solomon Brothers said that as a result of consolidations, mergers and buyouts, $95 billion worth of stock was removed from public trading last year -- about 4.5 percent of the total market value of all the stock in U.S. corporations.
If interest rates continue to decline -- as most experts think they will in the coming months at least -- then stocks will yield even more than today relative to bonds. Furthermore, lower rates will make it more difficult for pension funds to earn the kind of "immunized" return they need to provide the income and growth to satisfy expected pension claims.
But before stock investment becomes more popular, Merrill Lynch's McCabe said, there probably will be one more general stock decline that will take the Dow average to 1050 to 1100.
In other words, the stock market may be a good place to invest in 1985, but the investor will still have to face volatility. Whether investors are willing to accept the volatility, whether they will judge that the potential of stocks outweighs the risks and uncertainties is the major question for 1985.
One thing is certain: The big money managers whose clients account for the lion's share of both stock and bond trading have not done well. Last year, about 70 percent of the money managers earned less money for their clients than the average return on stocks and bonds. In part, that is an inescapable consequence of the increasing domination of institutional trading -- that done on behalf of pension funds, insurance companies and the like. "When you are the average, it's pretty hard to outperform it," said Balog.
On balance, to those who think economic fundamentals are the primary ingredient in determing both stock and bond performance, 1985 offers the usual jumble of prospects.
On the positive side:
* The overall economy seems to be headed for a desired period of sustainable growth -- fast enough to create new jobs but slow enough to keep demand pressure under control. The economy should grow fast enough to give a boost to corporate profits, enhancing the attractiveness of corporate stock.
* Inflation probably will remain moderate, at least by the standards of the last decade. Most economists expect a rate of inflation in the 4 percent to 5 percent range -- a level that triggered the 1971 imposition of wage and price controls but looks good compared with the double-digit rates of the late 1970s and early 1980s and comparable to the rates achieved in 1983 and 1984.
Oil prices appear headed nowhere but down. Most other commodity prices probably will remain equally weak in a period of large supply and restrained demand in Europe and Japan. The strong dollar -- which makes U.S. imports so inexpensive -- will continue to make it difficult for domestic companies to raise prices.
* Interest rates should retard the economy less than in 1984, in part because the Federal Reserve -- as its Chairman Volcker said Thursday -- feels more confident than it has in the last several years that it is winning the battle against inflation and does not need to run as harsh a monetary policy.
There are continuing problems, however, that, if not dealt with, could spoil the party in 1985 and very probably will before the end of the decade -- the massive U.S. budget deficit among them. Treasury demand for credit did not crowd out private investors last year, mainly because foreign savers found the U.S. capital markets attractive and supplied most of the funds U.S. borrowers needed.
Dean Witter's Sullivan said that the $200 billion deficit, one of Wall Street's major concerns since the beginning of the Reagan administration, receded as an issue in late 1984 because interest rates were declining. But the existence of the deficit still makes investors worry that inflation -- which gravely wounded the financial markets several years ago -- could rear its head again.
Wall Street seems unconvinced that the Reagan administration and Congress will take serious steps to cut the deficit. As long as foreign investors are willing to put their funds in U.S. capital markets, the big deficit need not rekindle inflation and interest rates. But at some point, nearly all experts agree, foreign desire for U.S. investments will moderate.
When that happens, if the deficit has not been sharply reduced, interest rates will skyrocket and the dollar will tumble -- and with it one of the major forces working to restrain inflation.
"There is no immediate concern" about either inflation or a decline in the dollar, Kaufman said. But Kaufman, like most other analysts, said he doubts that Congress and the administration will take the steps to reduce the massive budget deficit in time to prevent the inflation and interest rate consequences of the inevitable dollar decline.