by Tony Jackson - FT.com

Even among those perennially sunny souls, the equity strategists, there is a touch of gloom around. The credit game is up, it seems, so the equity game cannot be far behind. It is only a question of time, and not much of it.

Yet the Dow went through 14,000 last week and the S&P 500 hit an all-time high. Granted, that is in depreciated dollars. But it still seems a funny way to express apprehension.

Let us look closer at what some of the strategists are saying. The most popular bearish argument comes from Morgan Stanley. In simple terms, it says equity markets tend to crack on average six months after credit markets do. This time round credit first weakened in February, so mind out for August.

For all I know, it might indeed work out that way. The trouble with the argument, though, is that no rationale is offered for how the mechanism works. We have only an average drawn from selected historic observations.

The markets have always been drawn to the magic of fixed periods, for reasons that elude me. Chartists are fond of the Kondratiev cycle that says depressions occur every 50 years. But Kondratiev's theory was based on data from the 16th to 19th centuries. Why should the economy of the internet work to the same timetable as that of the oxcart?

Morgan Stanley points to the way credit spreads widened ahead of the crashes of 1987 and 2000. But today, credit and equities are more closely connected.

Credit and equity analysts sit alongside each other at the investment banks. Hedge funds routinely short a company's equity while going long of its bonds, or vice versa. It is no longer a matter of two separate investment communities viewing the world differently. The same community is observing the two asset classes and drawing different conclusions.

Why? A possible – if familiar – explanation comes from one of the few bullish banks still around, Citigroup. In recent years, we have seen "one of the biggest arbitrage trades in financial market history" – the massive use of cheap debt to buy cheaper equity. The arbitrage gap still exists, so the bull market is intact.

Citigroup flourishes a chart showing the global earnings yield on equities and a notional global BBB bond yield. At the last market peak in 2000, the bond yield was nearly 9 per cent and the earnings yield only just over 3 per cent. No wonder, as Citigroup observes, that private equity didn't join that particular party. The sums didn't remotely add up.

At present, the yield on both has converged to about 6 per cent. This is not quite a steal any more, but is not that different from the conditions of the past two-and-a-half years. Citigroup hazards a guess that for the arbitrage train to be derailed, BBB bond yields might have to rise by two percentage points, or earnings yields fall by the same amount.

BBB bond yields have certainly been rising, through a combination of higher real yields and wider spreads. But 200 basis points is not on the cards quite yet. As for an earnings yield of 4, that would involve the price-earnings ratio rising from its present 17 or so to 25, which is a very bullish scenario.

So everything is all right, then? Well, not really. The price of money is only one factor in the equation. Another is liquidity – which, as they say, is only another name for risk.

And there are all kinds of tell-tale signs that lenders are becoming more risk-averse. In such times, the wall of money argument becomes meaningless – think of the Japanese equity market after the 1990 crash.

One other word of warning. Citigroup takes it as a bull point that, whereas in the last bull market, all the big acquisitions were for equity, today they are still predominantly for cash. But when trouble hits, that could be profoundly bearish in itself.

At the peak of the M&A cycle, companies inevitably overpay. Think of two examples last time, Vodafone and Marconi. The first used equity, the second debt. The first survived and the second was destroyed.

One of the props for the credit markets just now is the absence of corporate defaults. Just wait, though, till some of those big cash mergers start turning turn ugly. I distrust pat formulas for when the credit bust will hit equities. But I don't doubt it will – eventually.

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