By the middle of October, the stock market had become a sitting duck, waiting for something to happen.

Stock prices had been sliding gradually downward since the end of August. The House Ways and Means Committee was about to approve a tax bill that would virtually stop the corporate takeover boom that had helped inflate stock prices.

Congress and the White House remained at an impasse over the budget deficit, leaving the economy dangerously dependent upon foreign lenders. The dollar seemed headed for another fall that would bring higher-priced imports and more inflation in its wake. And the Federal Reserve had tightened the supply of cash to the banking system to head off inflationary pressures. Then, on Wednesday, Oct. 14, that "something" the stock market had been waiting for happened.

Early that day, the Commerce Department published a long-awaited report on the nation's merchandise trade deficit, showing that the deficit in August had narrowed only to $15.68 billion from $16.47 billion in July. Worst of all, there was no improvement in exports. The result that day was a record drop -- at that time -- of 95.46 points in the Dow Jones industrial average.

The trade report was widely seen as evidence that the trade gap was not closing, as the administration had expected. A high-ranking State Department official said: "There was no way we could legitimately explain away the failure of exports to improve."

New York investment banker Geoffrey Bell said: "When we saw those trade figures, there was the realization that ... the trade deficit was not going to improve, that the dollar would have to go down, and interest rates would have to go up. And obviously, that wasn't going to be good for the economy. There was also the realization that sooner or later, foreigners would lose their faith in the dollar."

But there was more to the story than just the trade figures, and what happened that Wednesday was only the beginning of a collapse culminating in the massive 508-point free fall in the Dow on "Black Monday," Oct. 19.

There were two crucial factors, according to financial and market analysts.

Firts, rising interest rates had put the return on long-term bonds at better than 10 percent. "But when the Dow Jones index hit its peak in August, the stocks in that index were yielding {dividends of} only 2.58 percent," said investment adviser Sam Nakagama. Because of this huge gap, investors began moving from stocks to bonds.

Second, in the midst of growing concern over high interest rates and the dollar, Treasury Secretary James A. Baker III unintentionally sent a bad signal to the markets. Appearing in the White House press room on Thursday, Oct. 15, in an effort to calm fears after the Wednesday drop, Baker said he was unhappy with the West German policy of higher interest rates, and promised that the Federal Reserve would not boost rates in this country.

The implication of his statement was that the dollar would decline in value relative to the West German currency, and that the U.S. government would not try to stop the slide. A lower value for the dollar would add to inflationary pressures in the United States by boosting prices of imports.

"That was Baker's first mistake in managing international economic policy," said C. Fred Bergsten of the Institute for International Economics.

Perhaps worst of all, Baker's public potshot at the West Germans suggested that the international coordination process he had nurtured, keeping the dollar stable, was at an end.

A senior administration official said that Baker went public only after he had privately and repeatedly urged the West Germans to back off their high interest rate pattern, which he felt violated pledges they had reiterated only a few weeks earlier during the International Monetary Fund meetings in Washington.

But the real damage came not from Baker's Thursday remarks, but from a front-page story in the Sunday New York Times reporting that in "an abrupt change of policy" Baker was actively pushing the dollar down, and that a decline in the dollar was already in progress. Baker denied the story on last Sunday's "Meet the Press" program (and events have since borne him out), but that didn't alter the impression that he had made an about-face and no longer sought to keep the dollar stable.

Almost all market experts contend that what happened last week was to a large degree irrational. Said Nobel Prize-winning economist James Tobin: "There are no visible factors that could make a 30 percent difference" in the value of stock between Oct. 15 and Oct. 20.

To some extent, perhaps, what took over was the gut feeling that the stock market had been on a five-year upward trajectory not compatible with the enormous American budget and trade deficits. Many think that cumulative evidence of President Reagan's loss of governing power also took a toll.

It was in that context that the Baker episode was hurtful. Baker is perhaps the most highly regarded of Reagan's top advisers, particularly on Wall Street, because of his opposition to protectionist legislation and his efforts to unite international economic policies.

"Baker must have been fed up with the Germans," Bell speculated. "But what he apparently didn't realize was that confidence was so fragile at the moment he spoke that he couldn't do what he had done before. He couldn't publicly say to the Germans: 'Expand your economy, or I'll let the dollar fall.'"

Last Sunday night, as Baker prepared for a secret trip to Frankfurt, where he would meet with West German Finance Minister Gerhard Stoltenberg and central bank president Karl Otto Poehl, he could not have known how delicate the situation really was.

Had he known what was ahead on Monday, he wouldn't have gone on to keep a previously arranged, lower-priority meeting with the Swedish finance minister in Stockholm, a source said. By Monday night, after talking on the phone with chief of staff Howard A. Baker Jr., James Baker junked plans to be in Europe through Friday and hustled back on the Concorde to help shape the administration response to the market collapse.

In any event, the Baker-Stoltenberg-Poehl meeting last Monday at the Frankfurt airport apparently patched things up, at least temporarily: The West Germans agreed that they wouldn't push interest rates any higher for the moment, and all pledged that they would support a "flexible" policy toward adjusting U.S. and key foreign exchange rates.

Whether that will allow the dollar to move down against the West German mark, officials refuse to say. But observers will not be surprised to learn that agreement was reached for a dollar/mark exchange rate somewhat below the 1.80- to 1.90-mark "target zone" reportedly set in February at the Louvre Palace, when the Group of Seven agreed to stabilize currency rates.

If Baker's suggestion on Thursday, Oct. 16, that the dollar might be allowed to slide against the mark contributed to the market fears of inflation, few market analysts assign him primary blame. Most say that the underlying factors were controlling. But the Baker statement "may have been the icing on the cake," said Bell.

"The first point to bear in mind," said Robert Hormats, a Goldman, Sachs & Co. vice president, "is that many in the market had made enormous paper profits over the last couple of years and there was a growing feeling that the market was overvalued. So more and more of those who had made paper profits looked at the market more carefully, and at developments that might threaten those paper profits.

"Second, there had been in the back of investors' minds a growing concern about inflation -- more a concern about future inflation than existing inflation.

"By saying that, he {Baker} gave the markets a case of the jitters," Hormats concluded. To the extent that the stock market recovered last week, the experts suggest that it has been helped by a realization that the panicky Monday selloff went too far.

In addition, government authorities moved quickly after Baker returned to Washington to restore confidence in concrete ways. The chief confidence-boosting elements, almost all observers say, were Federal Reserve Chairman Alan Greenspan's prompt assurance on Tuesday morning that the central bank would pump money into the economy, and Reagan's first-time commitment to arrange an "economic summit" with congressional leaders, including Democratic officials, on the budget deficit -- one that might soften his well-advertised aversion to a tax increase.

At the end of the week, Baker was hard at work restoring his own image, negotiating with Congress on the budget package. "The market is looking for leadership, and it got it from the Fed and the White House after Baker got back from Europe," Hormats said.

Baker -- supported by chief of staff Baker and Greenspan, who sources say saw more of the inside of the White House in a week than his predecessor, Paul A. Volcker, did in a year -- persuaded the president to grit his teeth and open up the possibility of a deficit-reduction package that would include a tax increase.