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.