The risk/reward trade-off from betting on equity market Armageddon seems on a par with joining an end-of-the-world-is-nigh religious cult, writes Chris Johns

Equity markets keep heading up and the growling of the bears just keeps getting louder. The siren voices that warn we are just inflating another equity bubble - this one more broad-based than the last - are sticking to their guns and argue that it is all the fault of the Federal Reserve (the US central bank), whose chairman, Alan Greenspan, simply isn't putting up interest rates fast enough.

Markets beg to differ and are focusing on continuing signs of profit growth and an increasing number of reasons to be cheerful. Who is right and how should the individual investor position his portfolio?

The argument over the US revolves around our old favourites, those economic "imbalances" that will one day, we are told, give rise to financial Armageddon. The US consumer doesn't save a cent and the government's fiscal deficit is financed almost exclusively by Asian central banks, particularly the Chinese, who are desperately buying treasury bonds in an ongoing attempt to prevent their domestic currencies from rising against the dollar.

In buying bonds they are, it is said, merely inflating other asset prices, not just those of the bonds themselves. When bond prices rise, yields fall, and those yields provide benchmark valuations for equities and other assets, not least corporate debt. So when treasuries go up, so does everything else. Hence, if we are in a bond bubble, everything else is mis-priced as well.

The so-called bond bubble has been given another twist by the activities of some traders who have worked out that there is a free lunch available: borrow money from the Fed and lend it to the US government at a profit: for as long as Mr Greenspan persists in his determination to keep the real cost of short-term money at negative levels there is money to be made. At least that's the theory.

The basic idea is that we are living through another form of inflation, inspired as always by government and central bank idiocy, albeit a form of inflation different to the one that we are all used to. Bonds of all description are way over-priced, as is property and, more recently, equity markets. Commodities, particularly oil, are just a small part of a bigger inflation picture.

If all of this is being fuelled by interest rates that are too low for prevailing economic conditions, then the denouement will come with higher interest rates: all of those liquidity-fuelled investments will come a cropper when the cost of borrowing rises beyond a pain threshold. Alternatively, I guess, markets could just cop themselves on and work all this out for themselves and move to force the higher interest rates, and much lower asset prices generally, that the world is deemed to require.

It's a big call to say that the world's financial markets are wrong, but one or two people made their reputations making precisely this forecast during the technology boom of the late 1990s and reputations are once again being staked on an extreme view.

The world's most high-profile bear, Stephen Roach of US investment bank Morgan Stanley, is in the vanguard of a quite sizeable number of doom-and-gloom merchants who believe that we are heading for disaster.

The facts are on their side: the US is running unprecedented balance of payments deficits that look completely unsustainable. The US saving rate looks absurdly low. The build-up of dollar reserves by Asian central banks looks equally unsustainable.

But all of this has been known for some time. Indeed, Mr Roach is the first to admit that he has been warning about the consequences of the US's too low saving rate for years - and markets have rarely paid any attention.

His informal polling of investors suggests that money managers have a different view: Mr Roach describes it as a "muddle through" model of forecasting, a term I have used when discussing the outlook in previous columns.

"Muddle through" is a view of the world that acknowledges the facts of the pessimists case but one that goes on to argue that there is no analytical basis, no spread sheet or fancy mathematical formulation, that tells us how we move from the unsustainable to the sustainable or, indeed, when.

Mr Roach might be right but if we position our portfolios for disaster we might miss another year (or two or three) of strong equity performance. Markets are like that. To paraphrase another, usually bearish, commentator, I seem to have been worried about US imbalances for most of the past 20 years; perhaps it's time I got over it.

Eventually, the US consumer will have to spend less and save more. In the short term at least, that will entail lower economic growth. But that does not necessarily spell the end of the world for financial markets, particularly if the changes are relatively slow.

The more serious charge is that we are living through another liquidity-inspired bubble and that this one will end like all others, with a spectacular bust. This may be right, but it may not. My own hunch - and it cannot be more than that - is that Mr Greenspan is right and we should be quite careful with our use of the term "bubble". We are essentially describing virtually everyone else's behaviour as fundamentally irrational. That might be right but it is a big and brave call.

If the US does muddle through, eventually, with a period of subdued growth, the rest of the world's economies and financial markets will probably surprise us with how robust they prove to be. Even Europe might be OK.

The time to worry will come if there is a financial accident of one sort or another that exposes the frailties that so concern the doom merchants. The list of potential suspects is a long one: a sudden crash in bond prices, property prices or the dollar (or all three) are the macro worries; the potential failure of an over-leveraged financial institution is the micro worry.

For those of us who are paid-up members of the muddle-through club, we are essentially betting that if one of these accidents occurs we will be nimble enough to reposition our portfolios so that not too much damage is caused. Time will tell on this score, of course.

For now, the risk/reward trade-off from betting on Armageddon occurring imminently seems about as good as joining one of those end-of-world-is-nigh religious cults. I'm sticking with stocks.

Chris Johns is an investment strategist with Collins-Stewart. All opinions are personal.