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New York Market: Rally expected after Tuesday rate rise

EVEN with the Federal Reserve poised to raise interest rates, the Standard & Poor's 500 Index could be a buy. That's what some money managers argue, with the Dow Jones Industrial Average set to outpace the S&P 500 for the first time since 1996.

The Dow, up 21 per cent, has rallied in part because "value" stocks with low price-to-earnings multiples came into vogue. Yet some money managers make the case that interest rate concerns, which have hit more richly valued "growth" stocks, will lift and the Fed won't raise rates after this week.

"Inflation should surprise on the low side," said Richard Sichel, investment officer of Philadelphia Trust. "And then you'll start to see the S&P, which has been lagging the Dow by a fair amount, start to close that gap."

Bulls argue that after Tuesday, when the Federal Reserve is expected to raise its target for the overnight bank lending rate to 5.25 per cent, investors will focus on profits. Federal funds futures contracts, which signal where investors expect the Fed funds target to be in the months ahead, show that investors are prepared for a 25-basis-point increase. The yield on the contract for September delivery is at 5.22 per cent, almost a quarter-point higher than the current lending target. Most economists at big bond firms predict the Fed will raise rates on Tuesday for the last time this year.

"I'm betting on a relief rally on Tuesday," said Richard Eakle, chief of Eakle Associates, which oversees a hedge fund that is up 68 per cent this year. "All day I hear people saying a Fed increase is a fait accompli. The market's already made its adjustment."

A relief rally may already be in the works. Today, US stocks rose for the first time in three days and bond yields fell. Interest-rate-sensitive stocks such as the banks, beaten down amid inflation concerns, rallied.

Overall, the profit picture is bright. Earnings of companies in the S&P 500 rose 14.9 per cent in the second quarter. Analysts now estimate third-quarter earnings growth of 21.4 per cent.

Profit optimism wasn't reflected in stock prices last week. The Dow average rose 1.2 per cent for the week, the S&P gained 0.7 per cent, and the Nasdaq inched up 0.4 per cent. There are risks, though. The Fed could surprise the market and raise rates by 50 basis points. Or it could move a quarter- point and signal other increases are forthcoming; concerns about rates would continue, hurting virtually all stocks.