Felix and Oscar.

AN odd couple keeps popping up in financial forecasts for 2005: higher interest rates and higher stock prices.

The two are supposedly incompatible. An increase in interest rates works against profit growth at many businesses and adds to the allure of interest-bearing investments that compete with stocks for investors' favor.

Wasn't it declining interest rates that provided so much impetus for the great stock bull market of the 1980s and 1990s?

Well, yes, but the relationship is more complicated than it looks. That helps explain why some investors figure the stock market can do well even as the yield on 10-year Treasury notes rises to, say, 5 percent or 5.5 percent in the months ahead, from about 4.25 percent lately.

"I would get nervous if I saw interest rates crossing over 6 percent on their way to 7," says Hersh Cohen, co-manager of the $5.7 billion Smith Barney Appreciation Fund, at a year-end meeting with reporters. Short of that point, he says, "the stock market is much more vulnerable to upside surprises than downside surprises. Earnings are still going to go up. We're not facing a recession."

In the bulls' view, the Federal Reserve's moves since mid-2004 to raise short-term interest rates merely represent a withdrawal from extreme lows adopted as a temporary measure to forestall deflation.

"Rates are going back to a more normal level," said Joe Deane, co-manager of the $2.6 billion Smith Barney Managed Municipals Fund, who is more positive about prospects for stocks than bonds. "If rates are going up because business conditions are good, why should anybody in the stock market be upset?"

Recent history supports this argument. In the last three years in which l0-year Treasury yields rose, the Standards & Poor's 500 Index gained 26.4 percent (2003), 19.5 percent (1999) and 20.3 percent (1996).

The last three years in which l0-year Treasury yields declined, the S&P 500 dropped 23.4 percent (2002), 13 percent (2001) and 10.1 percent (2000).

The interplay varies, it would appear, depending on why rates are doing what they are doing, where we are in the economic cycle, and how the present cycle differs from the textbook template, as all cycles do.

It's illogical to suppose that stocks must also decline if the 10-year rate now goes back up. Even in the dismal world of economics, that would be double jeopardy.

With a little imagination, we can find several ways to view rising interest rates as bullish. For one thing, higher rates might let some air out of speculation that has pumped up prices of many commodities, including oil.

Secondly, increased borrowing costs might slow a runaway rise in real-estate prices that has surely drawn some money away from stocks. Thirdly, higher bond yields help ease a pension-funding squeeze that has been threatening the profit outlook in corporate America.

None of this justifies complacency about the investment outlook. No forecasts for 2005 can be taken on blind faith.

With the price-earnings ratio of the S&P 500 at 20 times the past 12 months' earnings, stock valuations give a pretty thin cushion against a sustained increase in bond yields.

Still, stocks have had plenty of advance notice lately to take the threat of higher interest rates into account. For the stock market to have a bad year in 2005, it will take something worse than a simple increase in the cost of money.

--Chet Currier, Bloomberg News