There are two ways to think about this. One is to think of these rich valuations and low prospective returns as a durable feature of the market environment. That's basically the vision that PIMCO's Bill Gross recently suggested, noting that we have entered a period of "negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come." His take is well worth the read. That said, an alternate possibility is that we will see a more rapid adjustment as investors lose the apathetic overconfidence that they can ignore the risks of a global economic downturn, massive and recurrent sovereign debt crises, and an implosion of the European banking system. In that event, we are likely to observe a significant increase in risk premiums toward more historically normal levels, but followed by a more gradual recovery in risk assets than the one that followed the 2008-2009 crisis.
My impression is that the Kraken is about to break loose, as valuations are rich and dependent on permanently high profit margins, speculators appear "all in" based on depressed bearish sentiment, mutual fund managers have whittled their cash holdings to nearly zero and have taken on unusually high beta risk, Europe is already in recession, and we are seeing a broad deterioration in U.S. economic data, as coincident evidence catches up with what we've persistently observed in the leading evidence in recent months.
Once upon a time, the stability of European government debt, the solvency of the European banking system, the prospects for the euro, and the speculative elements of the financial markets were all fairly distinct aspects of the financial landscape. Unfortunately, as the result of bailouts, monetary interventions, accounting changes, watered-down capital standards, and other kick-the-can strategies, all of these issues have become glued together, as the whole world has gulped down the elixir sold from the wagon of Ben Bernanke's Traveling Medicine Show. In response to strains in the European banking system due to risky sovereign debt holdings, the ECB made loans to those banks in return for "collateral" in the form of newly issued, unregistered bank debt, and the banks used much of the proceeds to take even larger positions in sovereign debt, against which no capital needs to be held. So rather than "fixing" the problem, the ECB simply bound the problems of the European banking system more tightly to its own balance sheet, and to the fiscal strains of European governments. Nobody cares right now - I get it. But understand that this is likely to end badly, particularly given that government debt typically grows sharply during recessions.
For our part, we would greatly prefer to deal with the adjustments that are necessary for robust economic growth, rather than just kicking the can down the road. This would include restructuring bad debt, removing the public and central bank guarantees that encourage reckless private behavior, establishing risk premiums that encourage savings, and reducing financial repression so that asset returns can provide useful signals for allocating capital well. Undoubtedly, central banks will fight against any of that, and the banking system will threaten "meltdown" in order to extract more bailouts in defense of bank bondholders. Still, it's worth repeating that even in recent years, Fed interventions have had their palliative effects precisely because they have emerged after the markets have already declined significantly. The hope of such interventions did not prevent significant downturns in 2011 and 2010, much less in the 2008-2009 period.
From a long-term perspective, the alternate courses don't mat