Wall Street has a problem: overvaluation

It's a fact of investment life that Wall Street remains extremely overvalued on any measure. The price-to-earnings ratio on the S&P 500 index is around 22 while the historic average is 14.

Moreover, this high ratio is post-September 11, Enron and the collapse of the Tech Bubble. Indeed, this is nothing new. For the past two decades US stock prices have grown faster than corporate profits and faster than national GDP. Business Week recently pointed out that total returns on stocks since 1982 had been 12% per annum, against a historic average of 7%.

You do not need the brains of Albert Einstein to see that this can not continue for ever. Just hark back to the recent past. From 1966 to 1986 US stocks delivered a 1.9% average total return to investors. For stocks can under-perform as well as over perform for lengthy periods.

In fact, in order to retrace their long term average return of 7% shares need to under-perform for at least a decade. Add to this the fact that a sharp upward movement in interest rates is on the cards in the US, and the outlook for shares is bleak indeed. So here is a classic case of famine following feast in the investment world.

Not that many mainline commentators yet espouse such a gloomy scenario. But the message is that cautious investors would be wise to avoid the US stock market for the time being, and it has to be said that the UK and European markets are likely to follow in its wake.

However, whatever the state of the market in general, there is always room for clever stock picking, and this will put an emphasis on obtaining the best advice from professionals. Mutual funds with the best managers will once again outshine those merely interested in tracking the market. There will also probably be a frightening crash at some point which will provide a buying opportunity for those with strong nerves and piles of cash.

All the same, the average investor may be in for a period where earning money on investments is very difficult. And that will not be news to the many millions of people who have lost money on the financial markets over the past two years. The bounce back may take a long time to appear.

For if Wall Street catches a cold then the rest of the US economy may feel it has pneumonia. Consumers will eventually feel less well off and spend less. Companies will expand more slowly because their access to capital will be more limited. And the holders of stock options will feel less incentive to put in long hours.

Nobody likes to hear this viewpoint, and it could prove too pessimistic, but have we not all been guilty of too much optimism for too long with regard to US share valuations?