Wall Street's bubble could burst soon

If you judge a stock market, like a suspected villain, by the company it keeps, then it is time to start getting very worried by what is happening on Wall Street.

As we approach the last gasp of the great bull market of the past two years (the Dow Jones index is up by two thirds in that time), you would have to be very foolish to ignore the voices that are warning investors to beware of the fallout from the inevitable puncturing of Wall Street's bubble when it comes.

The most important of these voices, of course, is that of Alan Greenspan, who as chairman of the Federal Reserve, the American central bank, has more power than anyone to change the directions of markets. Nine days ago, he sent markets the world over into a tizzy with some elliptical but carefully crafted musings about the risks to economic welfare posed by "irrational exuberance" among investors.

Since then, those who are paid to watch the Fed have been busy attempting to read deeper meaning into the chairman's words. Everyone knows he has been keeping a close watch in recent months on Wall Street for signs of excess. The surge of public and speculative money that has poured into US shares in the last two years must at some point run the risk of creating a dangerously inflated asset "bubble".

The immediate question among analysts has been whether the Federal Reserve is preparing to try and puncture the boom with a pre-emptive interest rate rise. Despite the initial panicky response, the reassuring view on Wall Street earlier this week was that norate rises are imminent and that the bull market case therefore remains just about intact.

But Mr Greenspan's intervention - whether it was a warning shot or a more serious threat to try and stop Wall Street in its tracks - has brought other concerns out into the open.

Whether it is seasoned investors such as Sir James Goldsmith, or respected market pundits such as Barton Biggs of Morgan Stanley and Henry Kaufman, late of Salomons, the heaviest hitters are nearly all on the side of those who are urging investors not to tempt fate by being sucked into Wall Street's all too "exuberant" rise.

In this column two weeks ago, I quoted the view of Peter Bernstein, another respected investment adviser, that while Wall Street might not be overvalued on conventional criteria, the risks of investing had risen sharply.

And only this week, Lord Rees-Mogg, the former editor of the Times, who has excellent contacts in Washington and the financial world, repeated his warning that a Wall Street crash is inevitable.

He made the point that if the dividend yield on the US stock market (now at a record low of just over 2 per cent) merely reverted to its long-term average (around 4.5 per cent), it would imply a fall in the Dow Jones index of no less than 70 per cent. His calculations suggest Wall Street is already discounting seven more years of 10 per cent growth in company earnings - despite the fact that the rate of profit growth is already very high by historical standards.

I have been impressed by the analysis done by Albert Edwards, market strategist at Kleinwort Benson, who has shown clearly (as my chart shows) that the improvement in companies' return on equity in the US is driven mainly by companies substituting debt for equity, not by any underlying improvement in the return on total capital employed.

This increase in gearing does raise return on equity - and therefore reported profits - but it also means (a) that investors are taking on greater risk than might at first appear; and (b) that in the same geared way, company earnings will fall much faster too when the next downturn comes.

The point is not that all these clever and experienced people might be wrong. Far from it; markets frequently make monkeys out of the most intelligent and well informed individuals. Nor is there is any inconsistency in saying markets are basically overvalued but may still rise further. Markets always do things to excess, and timing the turn is the hardest thing in the world.

In fact, it is perfectly possible to justify the current valuation on Wall Street. What matters to prudent investors is that they are aware of the risks they take on if they choose to ignore the warning voices.

When the chairman of the Fed starts making warning noises it pays to sit up and take notice. Not for nothing is the adage "Don't Fight the Fed" one of the oldest in Wall Street's lexicon.

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
Masterchef cooks Tony Rodd (left), Emma Spitzer (second left) and
Simon Wood (right) posing with judges Gregg Wallace (centre) and John Torode (second right), as the three will be seen cooking their hearts out in the hopes of winning the show.
TVReview: Tired Geography teacher John Torode and shaved Scotch egg Gregg Wallace crown the champion
Voices
Ukip leader Nigel Farage in Tiny Tim’s tea shop while canvassing in Rochester this week
voices
Life and Style
life
News
The Grand Palais in Paris will be transformed into a 4,000-seat cinema, with 44 double beds at the front
news
Have you tried new the Independent Digital Edition apps?
Finacial products from our partners
Property search
Put the phone down on the coldcallers who see pension liberation as an opportunity to liberate your pension from you

Pension freedoms: How to deal with cold calls from scammers

Sean O'Grady offers advice on keeping your money safe
Switching to a better bank account is much easier than it used to be

More people are switching current accounts – but what do the figures mean?

Experts disagree about the 7% increase over the past year

The chance of getting what appears to be free money can be hugely attractive, especially to first-time buyers who can be fooled into thinking it’s extra cash to buy the essential new items they need for their dream home.

Beware the boom in cashback mortgage deals

Too many mortgages are being sold with misleading gimmicks

The firm’s revenues slumped by a third to £217 million in a disastrous 2014

Wonga results could get even worse this year, chief admits

The firm’s revenues slumped by a third to £217 million in 2014

The cost of a buildings policy has dropped by 10.1 per cent over the year, with the cost of a contents policy falling by 8.2 per cent

Simon Read: Mild winter cuts the cost of home insurance

The average quote for a buildings and contents policy has fallen by 3.6 per cent

Don't count your retirement money yet: employers will stop receiving a pension rebate next year and their staff may lose out

Defined-benefit pension schemes: Rebate change in 2016 may leave you out of pocket

Employees in defined-benefit schemes are held up as the lucky ones, but the state pension scheme will be overhauled in April 2016
Labour will raise the national minimum wage to more than £8 an hour by October 2019 (EPA)

Barclays new Blue Rewards hands cash to customers. What’s the catch?

Joining Barclays Blue Rewards costs £3 a month but then lets customers in for handouts of up to £15 a month

New research reveals that despite the recovering economy, four out of five low-income households have seen no sign of their financial situation improving

Hard-up families could be eligible for financial help

A charity is urging anyone struggling financially to see if they could get help from the state

When is the best time to buy foreign currency?

Video: With an election looming, a hung parliament could hit sterling

General Election 2015: Vote for the party that will boost your finances

Experts warn that the general election is unlikely to lead to stable markets. Simon Read talks to two investment managers who are advising caution

Make the most of your money in 2015-16: The end of the tax year is the beginning of the next...

The new tax year brings with it a raft of new rules and regulations

General Election 2015: Will pension reform be a major factor?

Video: Tom McPhail, head of pensions at Hargreaves Lansdown, says May's outcome could alter your pension

General election 2015: David Cameron's promise brings uncertainty to investors

Video: Simon Read talks to Fidelity's Tom Stevenson

  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Ashdown Group: Business Analyst - Financial Services - City, London

    £50000 - £55000 per annum: Ashdown Group: Business Analyst - Financial Service...

    SThree: Trainee Recruitment Consultant

    £18000 - £23000 per annum + OTE £45K: SThree: At SThree, we like to be differe...

    SThree: Trainee Recruitment Consultant

    £20000 - £25000 per annum + competitive: SThree: Did you know? SThree is the o...

    Recruitment Genius: Administrator - IFA Based

    £22000 - £24000 per annum: Recruitment Genius: This is an opportunity to join ...

    Day In a Page

    Major medical journal Lancet under attack for 'extremist hate propaganda' over its coverage of the Israeli-Palestinian conflict

    Lancet accused of 'anti-Israel hate propaganda' over coverage of Gaza conflict

    Threat to free speech as publishers of renowned medical journal are accused of inciting hatred and violence
    General Election 2015: Tories and Lib Dems throw their star names west to grab votes

    All noisy on the Lib Dems' western front

    The party has deployed its big guns in Cornwall to save its seats there. Simon Usborne heads to the heart of the battle
    How Etsy became a crafty little earner: The online market has been floated for £1.2bn, but can craft and capitalism coexist?

    How Etsy became a crafty little earner

    The online market has been floated for £1.2bn, but can craft and capitalism coexist?
    Guy Ritchie is the latest filmmaker to tackle King Arthur - one of our most versatile heroes

    King Arthur is inspiring Guy Ritchie

    Raluca Radulescu explains why his many permutations - from folk hero to chick-lit hunk - never cease to fascinate
    Apple Watch: Will it live up to expectations for the man or woman on the street?

    Apple Watch: Will it live up to expectations?

    The Apple Watch has apparently sold millions even before its launch tomorrow
    Don't fear the artichoke: it's a good cook's staple, with more choice than you'd think

    Don't fear the artichoke

    Artichokes are scary - they've got spikes and hairy bits, and British cooks tend to give them a wide berth. But they're an essential and delicious part of Italian cuisine
    11 best men's socks

    11 best men's socks

    Make a statement with your accessories, starting from the bottom up
    Paul Scholes column: Eden Hazard would be my Player of the Year – but I wonder if he has that appetite for goals of Messi or Ronaldo

    Paul Scholes column

    Hazard would be my Player of the Year – but I wonder if he has that appetite for goals of Messi or Ronaldo
    Frank Warren: Tyson Fury will be closely watching Wladimir Klitschko... when he wins it'll be time to do a deal

    Frank Warren's Ringside

    Tyson Fury will be closely watching Wladimir Klitschko... when he wins it'll be time to do a deal
    London Marathon 2015: Kenya's brothers in arms Wilson Kipsang and Dennis Kimetto ready to take on world

    Kenya's brothers in arms take on world

    Last year Wilson Kipsang had his marathon record taken off him by training partner and friend Dennis Kimetto. They talk about facing off in the London Marathon
    Natalie Bennett interview: I've lost track of the last time I saw my Dad but it's not because I refuse to fly

    Natalie Bennett interview: I've lost track of the last time I saw my Dad

    Green leader prefers to stay clear of her 'painful' family memories but is more open about 'utterly unreasonable' personal attacks
    Syria conflict: Khorasan return with a fresh influx of fighters awaiting the order to start 'shooting the birds'

    Khorasan is back in Syria

    America said these al-Qaeda militants were bombed out of the country last year - but Kim Sengupta hears a different story
    General Election 2015: Is William Cash the man to woo Warwickshire North for Ukip?

    On the campaign trail with Ukip

    Is William Cash the man to woo Warwickshire North?
    Four rival Robin Hood movies get Hollywood go-head - and Friar Tuck will become a superhero

    Expect a rush on men's tights

    Studios line up four Robin Hoods productions
    Peter Kay's Car Share: BBC show is the comedian's first TV sitcom in a decade

    In the driving seat: Peter Kay

    Car Share is the comedian's first TV sitcom in a decade. The programme's co-creator Paul Coleman reveals the challenges of getting the show on the road