I recently read an investment newsletter from a not-so-prominent analyst cautioning his readers to 'Beware of Sideways Markets'.  He pointed out the obvious:  Margins are abnormally high, expectations for growth are high, and earnings multiples (cap rates for real  estate) are very high....All these result, directly or indirectly, from the Fed's zero interest rate policy.  The author concludes, 

Interest rates were much higher in the ’70s and early ’80s than they are today, and thus stocks may deserve higher valuations than they did then. This applies to all assets. But the Federal Reserve’s policy may inflate stocks’ valuations for a while. If the Fed succeeds and real growth resumes, then interest rates will rise and (expensive) stocks that were discounting all-time-low rates will get crushed. After all, they — like long-duration bonds — do great when interest rates decline and bite the dust when interest rates rise.

Of course, on many levels things are better now than they were in 2008. The financial crisis and real estate bubble are behind us; we are probably not going to see those again for a while. But their resolution came at a big price: much higher government debt and a command-control interest-rate policy that would have made the Soviets proud. We’re now living in a Lance Armstrong economy. We’ve consumed so many performance enhancement drugs through endless quantitative easing that it is hard to know how well the economy is really doing. Unfortunately, as Armstrong at some point did, we’ll have an Oprah Winfrey moment when the economy will have to fess up for all the QEs.

We are living through one of the most grandiose and untested lab experiments ever conducted by a central bank: QE Infinity. At the recent Berkshire Hathaway annual meeting, Warren Buffett said, “Watching the economy today is like watching a good movie — you don’t know the ending.” His sidekick Charlie Munger added, “If you are not confused about the economy, you don’t understand it very well.”

The Fed’s unprecedented intervention in the economy has increased the possible range and severity of negative outcomes, from runaway inflation to deflation or a freaky combination of the two (freakflation). Deflation (or freakflation) is not good for stocks or their valuations. Just look at Japan. Over the past 20 years, stock valuations declined despite interest rates being at incredibly low levels. Expensive stocks (as I’ve mentioned, stocks in general are very expensive) discount earnings growth. If growth fails to materialize, these P/Es will decline. Unknowns are simply unknown.

I could not help but nod my head in agreement with each paragraph.  Unfortunately, this is the dilemma for those investing in the current environment:  The expected return on most available investments is meager if even positive, and the tails are likely to be much fatter than in the past, i.e. the certainty of outcomes is much lower than at any time in recent history and the definition 'worst case' is also unknowable because there is no longer any available policy backstop to rescue an economy in crisis.

While we do believe finding good opportunities may become increasingly challenging for the next few months, we continue to like the notion of shorter duration loans with hard assets backing them at conservative loan-to-value ratios.  Clearly, holding a diversified portfolio of these loans does not completely eliminate downside in an economic collapse scenario.  Nonetheless, we do think it mitigates it significantly and will produce far better outcomes for investors than most other current investments offer.  Such a portfolio also performs acceptably in an accelerating inflation scenario given the increasing 'value' of the underlying asset and the ability to regularly reset rates on the portfolio.  Even in the new normal/new neutral scenario where growth is slow and erratic, a portfolio of senior secured private loans is likely to perform well because of the high rate of current income and possibility for a periodic workout that generates some additional capital gain.