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
Have you tried new the Independent Digital Edition apps?
Finacial products from our partners
Property search
Yorkshire Building Society is a leading player in offsets

Offset mortgages: How to save thousands of pounds and reduce the term of your home loan

Offset mortgages make even more sense when savings rates are at rock bottom

A physiotherapist helps a patient – a service one ex-employee was denied after paying for it

Questions of Cash: I've been chased for a phantom debt. What can I do to stop it haunting my credit status?

An Independent reader received a letter stating that a debt with O2 had been sold to a firm called Lowell Financial for collection

My Travel Cash card charges a punitive 'inactivity' fee of €2.50 a month

Simon Read stored the card away for 24 months, which cost him €60

Renting from a rogue landlord? It’s time to know your rights

Some 125,000 tenants have been victims of abusive landlords in the past year

This year's models: buyers have plenty of options as they try to get the money together to drive away from the dealer in a new car

Car finance options: Best way to buy a 65 plate

Sales could find another gear as the '65' registration hits the forecourts next week. Rob Griffin looks at the finance options
In too deep? Travel cover is among the benefits offered by packaged bank accounts

Claims firms blamed as complaints soar over packaged bank accounts

Many customers complained they were switched to the accounts without their knowledge

Finger on the interest rate trigger: the Bank of England

The best deals on personal loans: Peer-to-peer providers are more competitive for smaller sums

Meanwhile, high-street lenders continue to cherry-pick and be more competitive on larger loans

China stock collapse: Five things you need to know about 'Black Monday'

The market plummeted this week, losing all the gains made for the year

Which? warns sports fans about Rugby World Cup ticket scams

GetSporting.com offers deals that may be too good to be true

Could it be the time to focus on Japan? Some believe the country has no choice but to boost consumption and the economy will get back on track

Investors told to travel the world in the search for higher returns

Assets have risen in value across the board and volatility isn't going away. Rob Griffin asks where we should put our cash
As rising house prices push up demand for renting, so tenants are having to dig deeper than ever

Starter home initiative is urgently needed as rents go through the roof

Rents in England and Wales rose by 1.9 per cent in July to an average of £804

Peer-to-peer lending rates put Nisas to shame

The returns from P2P providers look more attractive than ever

Questions of Cash: Log-in problems turned eDreams booking into one-way ticket to nowhere

The company failed to provide our reader's flight ticket - or a refund

Hot property: business has been booming in estate agents this month, even though it’s the height of the summer holiday season

Heat rises for mortgage deals as UK homeowners sense a rate hike coming

The housing market should go quiet in August but instead people have been acting like cheap loans won't last. Do we really have to rush, asks Simon Read
Phones have now overtaken personal computers as the most used way of accessing the internet

Who you gonna call? The Complaints Busters

Unhappy customers have been given their own Ombudsman to help fight for them.

Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

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

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Sales Executive / Foreign Exchange Dealer - OTE £40,000+

    £16000 - £40000 per annum: Recruitment Genius: A Foreign Exchange Dealer is re...

    SThree: Experienced Recruitment Consultant

    £20000 - £40000 per annum + OTE + Incentives + Benefits: SThree: Established f...

    SThree: Trainee Recruitment Consultant

    £20000 - £25000 per annum + OTE 40/45k + INCENTIVES + BENEFITS: SThree: The su...

    Recruitment Genius: Collections Agent

    £14000 - £16000 per annum: Recruitment Genius: This company was established in...

    Day In a Page

    The long walk west: they fled war in Syria, only to get held up in Hungary – now hundreds of refugees have set off on foot for Austria

    They fled war in Syria...

    ...only to get stuck and sidetracked in Hungary
    From The Prisoner to Mad Men, elaborate title sequences are one of the keys to a great TV series

    Title sequences: From The Prisoner to Mad Men

    Elaborate title sequences are one of the keys to a great TV series. But why does the art form have such a chequered history?
    Giorgio Armani Beauty's fabric-inspired foundations: Get back to basics this autumn

    Giorgio Armani Beauty's foundations

    Sumptuous fabrics meet luscious cosmetics for this elegant look
    From stowaways to Operation Stack: Life in a transcontinental lorry cab

    Life from the inside of a trucker's cab

    From stowaways to Operation Stack, it's a challenging time to be a trucker heading to and from the Continent
    Kelis interview: The songwriter and sauce-maker on cooking for Pharrell and crying over potatoes

    Kelis interview

    The singer and sauce-maker on cooking for Pharrell
    Refugee crisis: David Cameron lowered the flag for the dead king of Saudi Arabia - will he do the same honour for little Aylan Kurdi?

    Cameron lowered the flag for the dead king of Saudi Arabia...

    But will he do the same honour for little Aylan Kurdi, asks Robert Fisk
    Our leaders lack courage in this refugee crisis. We are shamed by our European neighbours

    Our leaders lack courage in this refugee crisis. We are shamed by our European neighbours

    Humanity must be at the heart of politics, says Jeremy Corbyn
    Joe Biden's 'tease tour': Could the US Vice-President be testing the water for a presidential run?

    Joe Biden's 'tease tour'

    Could the US Vice-President be testing the water for a presidential run?
    Britain's 24-hour culture: With the 'leisured society' a distant dream we're working longer and less regular hours than ever

    Britain's 24-hour culture

    With the 'leisured society' a distant dream we're working longer and less regular hours than ever
    Diplomacy board game: Treachery is the way to win - which makes it just like the real thing

    The addictive nature of Diplomacy

    Bullying, betrayal, aggression – it may be just a board game, but the family that plays Diplomacy may never look at each other in the same way again
    Lady Chatterley's Lover: Racy underwear for fans of DH Lawrence's equally racy tome

    Fashion: Ooh, Lady Chatterley!

    Take inspiration from DH Lawrence's racy tome with equally racy underwear
    8 best children's clocks

    Tick-tock: 8 best children's clocks

    Whether you’re teaching them to tell the time or putting the finishing touches to a nursery, there’s a ticker for that
    Charlie Austin: Queens Park Rangers striker says ‘If the move is not right, I’m not going’

    Charlie Austin: ‘If the move is not right, I’m not going’

    After hitting 18 goals in the Premier League last season, the QPR striker was the great non-deal of transfer deadline day. But he says he'd preferred another shot at promotion
    Isis profits from destruction of antiquities by selling relics to dealers - and then blowing up the buildings they come from to conceal the evidence of looting

    How Isis profits from destruction of antiquities

    Robert Fisk on the terrorist group's manipulation of the market to increase the price of artefacts
    Labour leadership: Andy Burnham urges Jeremy Corbyn voters to think again in last-minute plea

    'If we lose touch we’ll end up with two decades of the Tories'

    In an exclusive interview, Andy Burnham urges Jeremy Corbyn voters to think again in last-minute plea