Warning lights start to flash over Wall Street

Up and up it goes and, if more and more pundits seem willing to predict that it will all end in tears, there is at this stage no end in sight. Wall Street's amazing surge continues, with new all-time records being broken week in, week out. At the start of the year, with the Dow Jones on 5,117, talk of it hitting 6,000 seemed fanciful. At the very least, a period of marking time seemed inevitable after a rise of 33 per cent in 1995. Now, in mid-February, the Dow is more than halfway towards that objective. Given the momentum in the market, it could easily reach it before long. But beware: this looks ominously like the final blowout before the bubble bursts.

For the time being, the market is underpinned by the prospect of falling interest rates. Hopes are riding high that the Federal Reserve will push down the fed funds rate to as low as 4.5 per cent by mid-year. If this led to a further fall in bond yields there could be an action replay of the virtuous circle of 1995, when the sharp and unexpected decline in bond yields spurred the equity market on to ever-dizzier heights.

The bulls' case is that the Fed will deliver the goods, propping up a sagging economy without reigniting inflation. That way share prices will benefit from a happy combination of lower interest rates, sustained economic growth and low inflation. Investors get the best of all possible worlds. But a number of warning signals are flashing red. For one thing, small private investors are flooding into the market via mutual funds as never before. With money market rates so low, it's easy to see the lure of equities. Traditionally, the arrival of small investor en masse has nearly always been a sign of disaster to come. As a rule of thumb, the small investor tends to buy at the top and sell at the bottom; he just loves to lose his shirt.

Another concern is the poor reception the US bond market gave to the last cut in rates by the Federal Reserve. The bond market has started to worry about the inflationary prospects that might follow the Fed's attempts to keep the economy growing.

With earnings growth apparently stuttering to a halt in the first half of 1996, the bulls are being forced to take a lot on trust. Already Wall Street is more highly valued on traditional measures than at any time other than before the last three stock market crashes. While corporate America is undoubtedly going through something of a renaissance right now, rediscovering its competitive edge internationally, it is hard to see how these valuations can be justified on fundamentals.

Wall Street's superlative performance in the past year has done much to drag the UK stock market, and world markets more generally, up in its wake. The takeover boom has helped in this process. A record pounds 43bn was spent in the UK on acquisitions last year, according to Central Statistical Office figures published yesterday. We may well see something close to that again in 1996 but London remains highly vulnerable to the all-too- likely Wall Street correction.