Let me preface this by saying this is not intended as a bullish forecast of equities. But, if equities decline, it will not be because P/E ratios are too high or profit margins are unsustainable. The reason is that the relationships between these measures and corporate values are not stable over time, especially when corporate leverage is changing.
First, let me compare firms with exactly the same operating results and sum-of-the-parts valuation premiums, but with differing levels of leverage. I will assume static interest rates and risk premiums, and book values equal to market values. (Edit: next line should say "different financial leverage".)
As firms deleverage, all else equal, valuations and net margins increase. These changing valuation metrics are not signs of truly higher valuation multiples. They reflect the fact that the equity holders are buying a fundamentally different security that happens to go by the same name.
If we think of equity as a perpetual call option on the firm's unlevered assets, then if we compare a firm at two points in time that moves from context 4 to context 3, we can treat the enterprise value as the asset price, the equity value as the strike price, and the annual interest expense as the option premium:
So, a firm that undergoes a fundamental change in leverage is like a call option with a different strike price. (As an aside, with options, the strike price is set and the premium changes with market sentiment. For a firm with stable leverage, the premium and strike price (interest expense and debt level) remain stable, so if market sentiment changes, it's the underlying asset price (enterprise value) that must change for the market to clear.)
Or, thinking of it another way, an investor with $500 million could borrow $500 million and buy Firm 2 at a firm P/E of 10, and get the same payout as she would if she simply bought the equity of Firm 4 at a firm P/E of 6.67.
Changes in these measures can simply reflect a change in leverage.
There are several financial market fundamentals that this simple model demonstrates.
1) The changing PE ratios are a product of the Equity Risk Premium, which changes as beta changes. If the volatility of the market as a whole changes, as the result of deleveraging or of improving growth prospects, PE ratios for the whole market will rise.
2) The debt in this model assumes negligible credit risk. Corporations normally use debt with credit risk, and the level of debt is determined by the leverage that produces the highest enterprise value, given the implied market risk premiums for different funding sources. There are a lot of moving values in that mechanism which the simple model above is not concerned with.
The point of this simple model is that corporations could be adjusting their leverage for reasons related or not related to the 2nd point above. A demand shock might cause corporations to delay some investments even though they don't want to shrink their capital base over the long run. Or, the market may be moving to an equilibrium with lower leverage for any number of reasons - equity investors may be less willing to pay for beta, pushing the market leverage level down.
High PE's can certainly signal a dear price. But, high PE's and high profit margins, together with lower leverage, can also, ironically, signal safety.