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The recent equity market rally is an opportunity to sell equities, because markets are expensive and, contrary to many expectations, corporate profits are likely to fall, according to the latest market outlook report from London research house Smithers & Co.

Corporate demand for shares, which has been the driving force for the stock markets’ recovery, has become corporate supply, with the notable exception of Japan, he notes.

Falling short-term interest rates have supported the US market, in line with the historic pattern. Unless growth is weaker than anticipated, certainly in stock markets, interest rates are unlikely to fall much further. But to keep inflation in check, growth must remain below trend, which means profits have to fall. The chance of a major decline in share prices are thus far higher than the chances of a major rise.

Bond yields, meanwhile, are too low, according to Smithers - particularly for long-dated UK index-linked bonds. Even though equities are overpriced, positive returns are available with only moderate risk over 30-40 years by equity purchases financed with long-term debt.

On a broader, global front, worldwide growth has been too rapid in recent years and inflation has picked up - in a new way, notes Smithers. It is not “cost push” as in the late 1970s and early 1980s, when wages drove up costs. The new “cost push” comes from the relative rigidity of raw material supplies compared to services.

It’s possible, though unlikely, that the rise in raw material prices so far is sufficient to increase their relative supply and stop further relative price changes, notes Smithers. A more likely scenario is that goods prices will now rise faster than service prices on a secular basis, reversing a long-term trend.

It follows, then, that the more developing economies support world growth, the greater will be the marginal demand for goods relative to services. “Decoupling”, if it occurs, is thus a mixed blessing. The more it occurs, in Smithers’ view, the slower the developing world can grow without inflation remaining too high.

In a separate report on bond yields and equity returns, Smithers notes that while yields on UK and US and long-dated indexed linked bonds have fallen to very low levels, the long-term real return on equities appears to have been stable at a level well above the current long-term real cost of debt.

At first sight, therefore, there’s a large gap between the likely real return on equities and the cost of borrowing.

So what are the likely risks and rewards for investors who might be considering a strategy to exploit this gap by borrowing to invest in equities?

Fine, it would appear, as long as the prospective return on equities be independent from the current costs of borrowing.