The ratio of market value to profits began a decline in the late 1960s that has continued fairly steadily ever since. The reason is inflation, which causes investors to commit two major errors in evaluating common stocks. First, in inflationary periods, investors capitalize equity earnings at a rate that parallels the nominal interest rate, rather than the economically correct real rate—the nominal rate less the inflation premium. In the presence of inflation, one properly compares the cash return on stocks, not with the nominal return on bonds, but with the real return on bonds.
Second, investors fail to allow for the gain to shareholders accruing from depreciation in the real value of nominal corporate liabilities. The portion of the corporation’s interest bill that compensates creditors for the reduction in the real value of their claims represents repayment of capital, rather than an expense to the corporation. Because corporations are not taxed on that part of their return, the share of pretax operating income paid in taxes declines as the rate of inflation rises. For the corporate sector as a whole, this effect tends to offset any distortions resulting from basing taxable income on historical cost.
If a firm is levered, inflation can exert a permanently depressing effect on reported earnings—even to the point of turning real profits into growing losses. On the other hand, a firm that wishes to maintain the same level of real debt despite inflation must increase its nominal debt at the inflation rate; the funds obtained from the issues of debt needed to maintain leverage will precisely equal the funds necessary to pay interest on the debt and maintain the firm’s dividend and reinvestment policies.
Rationally valued, the level of the S&P 500 at the end of 1977 should have been 200. Its actual value at that time was 100. Because of inflation-induced errors, investors have systematically undervalued the stock market by 50 per cent.