From 1966 to 1981, stock prices fluctuated wildly. They also failed to provide the attractive returns investors had come to expect over the 20 years preceding 1966. In fact, the inflation-adjusted value of the Standard & Poor’s 400 declined by about 50 per cent between 1966 and year-end 1981.

The collapse of the market was not not due to poor earnings growth. Earnings per share for the S&P 400 increased at a 7.5 per cent annual rate from 1966 to 1981, outperforming the 6.9 per cent annual rise in the Consumer Price Index. Rather, the culprit was a collapse in price-earnings ratios. After more than doubling over the two immediate postwar decades, P/E halved in the years from 1965 to 1981.

Application of a dividend valuation model to appropriate 1966–81 financial data indicates that three primary factors influence P/E ratios—inflation, corporate debt ratios and corporate profit margins. Over the 1966–81 period, unexpectedly high inflation rates drove investors away from stocks into alternative investment vehicles. With stock prices depressed, corporate managers turned to debt financing. As debt ratios, hence capital structure risk, increased, investors demanded even higher returns to hold stock. Finally, profit margins deteriorated as inflation continued to increase beyond the capacity of corporations to raise prices.