Even though US equity markets have had a rocky first quarter, and economic data is mixed at best, the bullish attitude is still in high gear, and successful value investors across the board have warned that when the market is happy we should be cautious.

“Optimists argue that the US and Europe are gradually recovering, Japan is successfully combating two decades of deflation, monetary policy will remain loose given that inflation is shackled, and though P/E ratios are high, they are not yet stratospheric,” writes Tim Tacchi, Chief Investment Officer at TT International, one of Europe’s largest hedge funds, in a recent white paper sent to investors. “There is some merit in all of these arguments.”

Global CAPE shows an overheating market

But Tacchi is also worried about the lack of concern over problems that are both obvious and potentially harmful down the road. While equity prices was soaring, consensus world GDP was falling for most of 2013, and has been volatile but trending flat since the end of last year. Global CAPE is its fourth highest level in history – and the other three highs were in 1929, 2000, and 2007 just ahead of market crashes.

You don’t have to think that there is an equities bubble to recognize that prices are high, and if economic growth doesn’t pick up we could be heading for a big correction.

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“The overall picture is one of growing risk and inadequate potential return in many markets around the world, yet investors seem alarmingly complacent,” writes Tacchi.

Europe growing complacent on deflation

The situation in Europe is equally worrisome, as the continent slides toward deflation. Tacchi argues that in reality, if you ignore the effects of austerity-driven tax hikes, most of the Eurozone has been in deflation since last summer. Even if people disagree about the absolute level of inflation or deflation right now, the trend is clear.

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Falling wages has been credited with helping to spur economic growth, especially in southern Europe, but when nominal wage growth falls below productivity growth then countries are necessarily in deflation. The combination of low inflation or deflation and an appreciating euro will make it harder for these countries to repay their debts, setting the stage for another sovereign debt crisis just waiting for a catalyst.

Tacchi isn’t bearish on Europe, he acknowledges that business activity is at its highest level in years and that government debt is finally coming down, but he warns that “there are signs of complacency from investors, many of whom are starting to forget the Eurozone crisis, despite many of its root causes remaining unresolved.”