By R Sivanithy, Senior Correspondent

NEWS last week that Wall Street's fat cats will have their pay cut and capped is indeed welcome, especially to a public lobbying for curbs on excessive risk-taking by unregulated banks.

Perversely though, it could divert attention away from other spheres of the financial world where there are clear signs of dangerous risk-taking that has inflated a huge bubble in stocks.

Where might this be? Clearly, it would be the hedge fund industry, where widespread use of derivatives, short-selling and complex instruments proliferate, and where there exists no meaningful regulation to protect the public's interest such as proper disclosures.

Why hedge funds? Because it is highly unlikely that any real trouble could come from the banks. After a tumultuous 18 months and with the eyes of all regulators trained upon them, how plausible is it that US banks would throw caution to the wind and start taking on the same, huge risks they did in 2002-2007 when they assisted in inflating the sub-prime bubble?

In our view, if you accept that Wall Street is now in bubble territory, then it is the hedge fund industry which needs to be urgently looked at, because any collapse in this area could set off the same chain reaction experienced in 2008 when US banks went bust.

First, is Wall Street in bubble mode? Probably yes, thanks to the actions of those bubble-blowers of last resort, the US Federal Reserve and Treasury who have given billions to prop up a failed financial system which includes banks which are still not lending. As a best-guess, it's very likely that the money pumped into the system has instead found its way into stocks.

In a comment last week (BT's Hock Lock Siew, Oct 21 'Are equities still cheap?') we pointed out that Wall Street is trading at historically high valuations which are not supported by its dividend yields and that with only anaemic growth to look forward to, current prices - in the US as well as this region - are likely too rich.

In this connection, it might be worth noting a recent report by ex-Merrill Lynch strategist David Rosenberg, now chief economist and strategist at Canadian wealth management firm Gluskin Sheff & Associates, in which he warned that US equities today are carrying too much risk.

'An unprecedented, eight-point price/earnings multiple expansion during a six-month, faith-based rally has left the market at its most expensive (26 times operating profit, 180 times reported profit) in seven years,' wrote Mr Rosenberg.

'On a reported basis, this market is almost four times overvalued, as it was during the tech bubble.'

His analysis also looked at what happens to the market after the PE rises above 25 - the average total return a year later is -0.3 per cent and the median is -6.2 per cent.

Using bond market data, Mr Rosenberg also found that if the market had discounted the correct GDP contraction, the S&P 500 should have bottomed at 315 instead of the 666 low reached in March.

Alternatively, since the bond market is now discounting 2 per cent GDP growth, the same analysis suggests the S&P 500 should be trading at 842, instead of above the 1,000 mark.

However, although Wall Street is decidedly too optimistic and, as Mr Rosenberg correctly points out, has benefited from a rally largely based on faith (that US officialdom will bail the market out in times of trouble), it might still be able to add a little to its present position, but not a lot.

Investors should never try to chase a market at its highs, just as they shouldn't attempt to pick the absolute bottom because it simply isn't possible to get it spot on all the time.

So what's the best course of action? For the best part of April-September, this column has advocated playing the recovery as a 'V-shape' but to always be mindful that 'U' or 'W' is just as likely. For those five months, the advice has also been to 'buy the dips and sell into strength'.

Both pieces of advice are probably still useful but what is troubling is that since risk-taking will surely be curbed among banks, it has logically been shifted somewhere else.

In our view, it is hedge funds that need to be looked at, and so far, no one is.

This article was first published in The Business Times.