By Michael Sivy

(MONEY Magazine) – It's only a matter of time. Federal Reserve chairman Alan Greenspan's loudly proclaimed decision in early February to raise short-term interest rates signals the beginning of the end for the record 40-month stock market advance. At no time this century have stocks moved up for so long without a decline of at least 10%. Now, with Greenspan at the rate ratchet, the stock market can look forward to a drop of at least 15% in the next six months. We have seen the power of falling rates since 1989, when the Fed started steadily cutting short-term rates from nearly 10% to the recent 3% level. That seven-point decline helped fuel the bull market that sent the Dow Jones industrial average rocketing from 2365 in 1990 to nearly 4000 in January. Now we're about to be reminded of what rising rates can do. Greenspan, in an unprecedented public announcement, has committed the Fed to boosting rates to quash inflation, even though inflation was running at only a 1.9% annual rate in last year's fourth quarter. One result of this pre-emptive strike will be lower stock prices. But, in general, market experts are split between two scenarios: -- The best case. Most forecasters are optimistic. They say the economy will slow from last quarter's 5.9% growth rate but will still roll along at better than 3% this year. Inflation will creep up, but just to the 3%-to-3.25% range. The Fed will therefore raise interest rates to only 3.5% -- or 3.75% at the outside. Stock prices will dip to 3650 at the lowest and tread water for a month or two. Then prices will start increasing again, and the Dow could reach a new high above 4000 by year-end. -- The worst case. A few analysts think the odds are better than fifty-fifty that we'll get steeper rate increases this year. Higher rates, in turn, will trigger a full-fledged bear market -- a 20%-plus decline lasting longer than 12 months. "Anything more than a half-point increase in interest rates will turn Wall Street on its ear," says James Stack, editor of the newsletter InvesTech in Whitefish, Mont. He notes that in six of the past seven recoveries that followed a recession, once the Federal Reserve began lifting short-term rates those rates continued to rise two percentage points or more over the following 18 months. We don't buy either scenario, however. We are sticking with the view we first laid out in our year-end forecast issue for '94. There we predicted that short-term interest rates would rise to 3.7% and that rates on long-term Treasury issues could top 6.75% (up from 6.4% now). That's still our outlook. We also expect the Dow to drop more than 15% from its January high to below 3400 by late summer. Then, it will most likely rebound to end the year above 3800 -- or slightly higher than it started. But no matter what you believe is going to happen to interest rates, you should take a defensive stance to protect your investments. If you've been riding this bull market, you may well have as much as 60% of your money in stocks. Start steadily trimming back now. At the same time, keep your eye on short-term interest rates. The stock market may easily absorb a half-point increase in rates, but if rates go higher you should brace for a 15%-plus decline in share prices. The best bellwether, according to Stack, is the yield on 90-day Treasury bills. If that rate, currently 3.2%, tops 3.5%, cut your stockholdings sharply. Even so, you should never have less than 30% of your portfolio in stocks (for the reason why, see Wall Street on page 56). As for bonds, start slicing them back too. And don't buy any new ones. The bond bonanza is over until the next recession begins and rates start falling again. Don't buy any shorter-term issues with maturities of two to five years right now either. Although they won't lose as much as long-term bonds would, they will still be subpar investments as long as short-term interest rates are rising. Our advice boils down to a single imperative: Put your money in money. We're talking Treasury bills, money-market funds and CDs. If short-term rates do top 3.5%, you shouldn't be afraid to let your cash holdings balloon to half your total assets. Then scout for buying opportunities. If the Dow tumbles to less than 3400, you'll see a wealth of first-rate stocks selling at wonderfully cheap prices. At that point, just when other investors are bemoaning their losses, you'll be able to go on a fabulous shopping spree.