Why danger lurks behind the razzmatazz of Wall Street

Soaring IT stocks have led the Dow to levels that looks perilously overvalued. Clifford German reports

A great cheer went up on Wall Street on Tuesday when the Dow Jones index broke briefly through the 10,000 mark. The level did not hold for long, and although it crossed it again on Friday, it closed at 9,903.55.

It is not surprising that the index slipped back again. The surprising thing is that it has got anywhere near that level at all. Wall Street has risen almost five-fold in the past 10 years and tripled in the last five years alone - a pace of growth that makes the tripling of prices in the UK and Germany over 10 years look pedestrian and the halving of the Nikkei index positively embarrassing.

Stock markets cannot prosper for long if the underlying economy where profits are made is doing badly, but economic growth is clearly not the only factor at work. The US economy has done well in the past 10 years but not that well. The real economy has grown by an average of 2.5 per cent a year, or 30 per cent overall, outpacing the UK, Germany and Japan. But that alone does not explain the superior performance of Wall Street. The explanation lies in the way in which the US economy has grown, not the amount.

Much to the surprise of most observers, who felt the US economy had prospered in the 1970s on a mountain of debt, which would eventually undermine it all, the US has grown by exploiting new technology and especially information- based technology; by improved use of fuel and raw materials; and by making better use of its labour force. The hourly wages of Americans have not reflected the growth in the economy, especially for those who have been driven out of the factories and forced to take low-paid insecure jobs in the service sector. But the transfer has kept down social security costs and prevented wage inflation.

In fact US inflation has fallen from more than 5 per cent in 1990 to less than 2 per cent, and US investors no longer feel they have to build in a fat nominal return to protect their real returns. Dividends also matter less when investors are making substantial capital gains. Total returns on Wall Street have been negative in only two of the past 10 years and have ranged from 10 per cent to 37 per cent in eight of the last 10. If this can continue, it is hardly surprising that investors are now willing to pay 34 times the average earnings on top US shares and accept dividend yields of less than 2 per cent.

Profits have grown appreciably faster than earnings, shifting the classic division between labour and capital decisively in favour of the latter. The US is also enjoying the fiscal benefits of a boom because government tax receipts are strong and the budget deficit is not a serious problem.

These trends cannot go on for ever. A continuing shift in advantage from labour to capital will start to reduce demand in the US economy. The massive US trade deficit is a more immediate worry. The rest of the world is only too happy to allow the US to run a trade deficit to help pull other countries out of recession, but there are fresh signs of discontent in other developed economies at the way the US is always able to pay for its imports by printing dollars.

The fact that US investors can now get three times as much income from bonds than they can from shares is another danger sign, and this contrast will become much more obvious as soon as the stock market stops climbing and capital gains turn into capital losses. The US stock market is not as overvalued as a static comparison with previous bull markets would suggest, but it still looks overvalued.

The UK economy has been travelling along the same path as the US, making more efficient use of labour, shifting the balance of advantage in favour of capital, and bringing inflation and budget deficits under control, with similar effects on the stock market. Share prices have risen to 25 times earnings, and dividends yields have dropped to 2.5 per cent - half the return on government bonds. In recent years the FT-SE index has underperformed the Dow Jones but it could have further to go before it peaks.

European stock markets have performed strongly through the 1990s, helped by increasing liquidity and hopes of mergers in the single European market. But the behaviour of the Japanese market shows that nothing goes on for ever. In the 1970s and 1980s, the Nikkei rose to dizzy heights because Japanese companies were growing on export earnings and investors were chasing capital gains and ignoring the negligible dividend yields.

When the bubble burst investor confidence collapsed and shares looked ridiculously overvalued. It is still too soon to say that the Japanese market looks cheap.

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksA celebration of British elections
News
Tottenham legend Jimmy Greaves has defended fans use of the word 'Yid'
people
Life and Style
tech
Arts and Entertainment
Kanye West, performing in New York last week, has been the subject of controversy as rock's traditional headline slot at Glastonbury is lost once again
music
Arts and Entertainment
The Ridiculous Six has been produced by Adam Sandler, who also stars in it
filmNew controversy after nine Native American actors walked off set
Life and Style
Google celebrates Bartolomeo Cristofori's 360th birthday
techGoogle Doodle to the rescue
  • 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.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Claims Administrator

£16000 - £18500 per annum: Recruitment Genius: This is an excellent opportunit...

Recruitment Genius: Senior SEO Executive

£24000 - £28000 per annum: Recruitment Genius: A Senior SEO Executive is requi...

Recruitment Genius: Online Customer Service Administrator

£16000 - £18000 per annum: Recruitment Genius: An Online customer Service Admi...

Recruitment Genius: Digital Marketing Executive

£18000 - £22000 per annum: Recruitment Genius: This global, industry leading, ...

Day In a Page

Fishing for votes with Nigel Farage: The Ukip leader shows how he can work an audience as he casts his line to the disaffected of Grimsby

Fishing is on Nigel Farage's mind

Ukip leader casts a line to the disaffected
Who is bombing whom in the Middle East? It's amazing they don't all hit each other

Who is bombing whom in the Middle East?

Robert Fisk untangles the countries and factions
China's influence on fashion: At the top of the game both creatively and commercially

China's influence on fashion

At the top of the game both creatively and commercially
Lord O’Donnell: Former cabinet secretary on the election and life away from the levers of power

The man known as GOD has a reputation for getting the job done

Lord O'Donnell's three principles of rule
Rainbow shades: It's all bright on the night

Rainbow shades

It's all bright on the night
'It was first time I had ever tasted chocolate. I kept a piece, and when Amsterdam was liberated, I gave it to the first Allied soldier I saw'

Bread from heaven

Dutch survivors thank RAF for World War II drop that saved millions
Britain will be 'run for the wealthy and powerful' if Tories retain power - Labour

How 'the Axe' helped Labour

UK will be 'run for the wealthy and powerful' if Tories retain power
Rare and exclusive video shows the horrific price paid by activists for challenging the rule of jihadist extremists in Syria

The price to be paid for challenging the rule of extremists

A revolution now 'consuming its own children'
Welcome to the world of Megagames

Welcome to the world of Megagames

300 players take part in Watch the Skies! board game in London
'Nymphomaniac' actress reveals what it was really like to star in one of the most explicit films ever

Charlotte Gainsbourg on 'Nymphomaniac'

Starring in one of the most explicit films ever
Robert Fisk in Abu Dhabi: The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers

Robert Fisk in Abu Dhabi

The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers
Vince Cable interview: Charging fees for employment tribunals was 'a very bad move'

Vince Cable exclusive interview

Charging fees for employment tribunals was 'a very bad move'
Iwan Rheon interview: Game of Thrones star returns to his Welsh roots to record debut album

Iwan Rheon is returning to his Welsh roots

Rheon is best known for his role as the Bastard of Bolton. It's gruelling playing a sadistic torturer, he tells Craig McLean, but it hasn't stopped him recording an album of Welsh psychedelia
Russell Brand's interview with Ed Miliband has got everyone talking about The Trews

Everyone is talking about The Trews

Russell Brand's 'true news' videos attract millions of viewers. But today's 'Milibrand' interview introduced his resolutely amateurish style to a whole new crowd
Morne Hardenberg interview: Cameraman for BBC's upcoming show Shark on filming the ocean's most dangerous predator

It's time for my close-up

Meet the man who films great whites for a living