Two ominous charts on the financial markets

TINA. There is no alternative.

When required to be fully invested this is trueish.

However you can sit in cash while no appealing investments exist. And buy in size when prices become more appealing. 

inb4 market timing is not possible

Have a look at Warren Buffett's track record and the amount of cash he held in early 2000 and now.

Options Nitpick: You can't use equity index* option prices as true probabilities because adding hedges to a portfolio makes the whole portfolio more valuable. People then buy options based on their value when added to the portfolio, not as individual investments.

The first reason option hedges make your portfolio more valuable is preferences: people don't just want to maximize their expected return, but also reduce the chance they go broke. People don't like risk and hedges reduce risk, ergo they pay more to get rid of risk. However you can't just subtract X vols to adjust as this "risk premia" isn't constant over time.

Secondly hedges maximize long term returns (or why you shouldn't sell options) You want to maximize your average geometric annual return not average annual return. You care about geometric averages because if for 3 years your returns were +75%, +75%, -100%, your don't have 50% more money then when you started but 0. The average of annual returns was 10.7% over the past 30 years, but if you'd invested in 1992 you'd've only compounded at 8.5% year till 2022.

Geometric returns are the the nth root of a product of n numbers and have the approximation = Average Annual Return - (variance/2). If you could reduce variance and not reduce Annual returns, your portfolio (market + hedges) would grow faster than the market.

These reasons are why despite the worst Annual return being -48% in 1931, you say there's a 5% chance of > -50% returns based on option markets.

*I'm specifically talking index options because that's the portfolio investors have (or something similar) and the total is what they care about. If you were to use prices as true probabilities for say a merger going through these reasons don't apply as much and would be more accurate.

PS. I've referred to investors as all having the same portfolio because most people do have highly correlated index holdings and it's at this level of generality you can think about investors as a class.

Which decades are you looking at? As recently as the decade before last (2000s) we had negative real (and nominal) returns for 10 years.

Sorry, I should have made that more clear. I am talking about the period since the start of the interest rate decline (mid 1980s to today).

"c) The change in the interest rate environment and the inexperience of the vast majority of players with such a change can lead to price movements that go far beyond usual price movements in the business cycle."

I'm not sure this sentence makes sense?

Let me try to rephrase that: I think we will be seeing a fundamental change in the financial markets due to an end to the 35year long reduction of real interest rates. And most of the actors have only known investing in an environment with more or less constantly decreasing real interest rates. I believe this combination could lead to widespread panic in the markets once the people making investment decision realize that they don't know anymore how the markets react due to the new environment.

Therefore we should expect forward returns to be low. The problem (for me) is there isn't much to be done about this. TINA. There is no alternative.

I believe that rationale for investing in equities is quite widespread today. Obviously, there is an alternative (accepting secure negative real returns), but in order to avert guaranteed losses investors take on risk. I am not saying that this is necessarily the wrong strategy, but it poses an interesting question: How will investors with this motivation for holding stocks react in a downturn?

The bond yields in your second figure are obviously not adjusted for inflation (ie, they are nominal yields, not real yields after inflation). So I'm not sure one can draw much of a conclusion from it.

That's true, I should have used a chart with real interest rates (I chose that specific graph because it was the one that made the problem salient for me when I had first seen it).

However, with real interest rates it looks similar:

are the "adjusted earnings over the last 10 years" adjusted for inflation?

Generally CAPE past earnings are adjusted to inflation.

Historically the stock market has responded badly over time to a rapid change upwards in inflation particularly if interest rates rise correspondingly, due to valuation effects ("net present value") . Subsequently once the market has fallen it tends to act as a reasonable inflation hedge. Typically this occurs around the point when Time Magazine has a front cover saying something like "The Death of Equities".

Different stocks respond differently to inflation. Consider the analogy of the Nifty Fifty of the late 1960s and the high flying tech stocks of today.

I’m not sure you can resize in the editor. If the image sizes on the sites you got them from are small by default, causing them to be small here, maybe zoom way in on the originals in your browser, screenshot them, and try re-uploading the resulting larger images?

d/ is actually completely consistent with the vol market (I point this out here [LW(p) · GW(p)]), so it's not clear that's their recommendation.

Am curious, are you suggesting any actionable trading strategy?

No, primarily I wanted to point out certain risk factors. The last sentence of my post was meant primarily as an illustration of the sentence before that.

d) sounds like you might be suggesting long vol, are you suggesting that?

Based on the risk factors stated above (but also based on the fact that overvaluations can be quite long lasting) I think most likely is one of two scenarios: A continued increase in the stock market based on the feeling of "there is no alternative" or a marked reduction of equity prices, so basically a bimodal distribution of expected returns. 

Whether this is already priced in in the current option market I don't know. (And since I don't do short term trading I don't really care that much.) Without a specific prediction for the distribution of the expected returns (which I am unable to give above the more qualitative statement in the previous paragraph) I think it isn't possible to answer that.