John Rapley

Wall Street legend has it that in 1929, John D. Rockefeller bailed out of the booming market when a shoeshine boy gave him a stock tip. Soon afterwards, the stock market crashed.

The tale may be apocryphal but it embodies age-old investor wisdom: when a wave of unconstrained optimism grips the market and everyone is getting in on the action, it's time to get out.

I thought of this a couple of weeks ago when I was watching an American television panel discuss the presidential election. The conversation came to the economy's impact on the campaign, and one panellist was asked the prognosis for 2007. "Fantastic" replied Jim Cramer, who went on to rhapsodise about a future of rising profits and falling inflation, and how this was the best of times to invest.

Fantastic. Now, I don't make a living from studying the U.S. economy, as does Mr. Cramer. Still, I know enough to say that unless you're a motivational speaker whose task it is to big up the self-esteem of an underconfident economy, it's a bit of a stretch to apply the word 'fantastic' to the current American economic outlook.

From what I can tell from surveying the literature, the consensus seems to be that the U.S. economy will continue growing, but more slowly than before; that employment and wages may pick up, which is good; but that productivity may decline, which is bad. This means that inflation will remain a threat. That, in turn, suggests that interest rates could continue rising. Profits, moreover, may have peaked. Taken together, this would suggest that this year mightn't be the best of times for stocks.

Then again, it might. For all the money that brokerages invest in predicting the future, the track record of economic forecasters is little better than a coin-toss. Nevertheless, modest optimism, tempered by a dose of caution, seems in order.

Stock-picking programme

Not, apparently, for Mr. Cramer. A firm believer that the benefits of stock-market wealth should be brought to ordinary Americans, Mr. Cramer is best known for his popular stock-picking programme on CNBC. To reach an audience dulled by reality television, he dresses up the show with lots of blinking lights and buffoonery. Call him the shoeshine boy's twenty-first century tribune. And he was telling all the shoeshine boys to get in on the action, and get in now.

The next day, stock markets around the world plunged. They've been having a rough ride since. Obviously, Mr. Cramer had nothing to do with it. But his brash optimism may be symptomatic of a contagion that may be behind the woes.

In the last few years, the loose liquidity policies employed by the world's major central banks apparently created an excess of liquidity in the global financial system. As too much money sloshed around the world, asset-prices rose, to the delight of sages like Mr. Cramer. Eventually, they rose so high that it got hard to keep making money. So investors chased higher-risk returns.

In the U.S., these returns were found in the high-risk mortgage market. Money became available to home-buyers who were otherwise considered too risky for credit. This drove demand for houses, and supported the economy.

Inflation then set in, so the U.S. Federal Reserve Board had to raise interest rates. This choked off the boom. Now, as mortgage defaults rise, investors in high-risk assets could get burned.

All through the boom, prudent voices were saying investors were being careless. The optimists, like Mr. Cramer, happily dismissed them and said that the sky was the limit. As this year unfolds, they may have a lot to answer for.