Beware the froth in the stock markets

Onwards and upwards. Early this week the Dow Jones index reached 16,000 for the first time, and the S&P 500 hit 1,800. It has gained 26% this year and is heading for its best annual performance since 1997. European equities are at a new five-year high.

The latest jump came after the new head of the US Federal Reserve, Janet Yellen, hinted that the central bank's money printing would continue for the next few months. That means liquidity-addicted equity investors look set to keep partying at least until the end of the year. But all this exuberance is far from rational. Yellen insists that these "are not bubble-like conditions". But the Fed has been so poor at spotting and dealing with bubbles that it is practically a contrarian indicator.

Stocks may not be experiencing the manic surge seen at the turn of the century, but they don't have to be "showing dotcom-style exuberance for a horrific market crash to follow", says James Mackintosh in the Financial Times. In 2000 the cyclically adjusted price/earnings ratio (Cape) of the S&P 500 hit 45. In 2007 it was around 27.

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As regular MoneyWeek writer Tim Price notes in his latest Price Report newsletter, since 1880 every time the Cape has traded above its current level of 24 it has foreshadowed very poor long-term returns. "Be well aware of the historic overvaluation" of US stocks. The long-term Cape average is around 16.

The fundamentals are hardly exciting. The US market has gained 25% this year, says Ben Inker of GMO, but earnings are up just 3% in a lacklustre economy. To make matters worse, profit margins are near record highs. Given their tendency to revert to the mean, "the likelihood of strong profit growth from here is pretty dim". As for interest rates, they have nowhere to go but up. There are other signs of overexcitement. The median American stock is at a new record on a price-to-sales basis. US inflows into funds and exchange-traded funds are set to top $450bn this year, more than the previous four years combined.

Investors who think we are in a new world of permanently high profitability and permanently low rates "might be able to justify buying shares", says Mackintosh. "Others should be worrying about froth." European equities look a better bet, with Capes still low enough to imply good long-term returns. But as they are strongly influenced by Wall Street, their appealing valuations don't rule out a nasty near-term jolt.