Regardless of what many people think, stock multiples are not too high. They are about right for today's low-inflation economy. This makes the corrections now taking place a buying opportunity.

It all gets back to interest rates. Since August 1981 stock prices have increased more than tenfold. This looks scary until you compare it to the value of the 30-year, zero coupon Treasury strip—think of this paper as the value of long-dated cash flows. The 30-year Treasury bond, stripped of interest coupons, has gained twentyfold over the same period. In short, the value of future income streams went up, regardless of whether the source was stocks, bonds or other claims. The longer the maturity, the more all claims rose in value.

This is humbling for stock market investors, including this one. Had we focused on that simple factor and forgotten the subtleties of security analysis and economics, we would have done better for ourselves and for our clients. We should have seen that falling inflation was increasing the value of any income stream. Once this became apparent, people pulled money out of tangible assets—seen as an inflation hedge—and moved into paper assets. In 1981 U.S. investors had 52% of assets in financial form. Today 70% is held in financial assets, like stocks and bonds. Disinflation has been a great boon for financial assets.

Since 1990 the main driver for disinflation has been massive property deflation in Japan, where land values have declined for seven years in a row. They stand at about 10% of their 1989 levels. Now Japanese property deflation has spread to the rest of Asia. Deflation in Asia acts as an anchor on U.S. interest rates. By reducing Asian consumption of cement, steel, oil and other industrial commodities, Asian deflation pushes dollar commodity prices lower and restrains inflation. Japan's bad luck has been our good luck.

As long as property deflation continues in Japan and the rest of Asia, U.S. stock market multiples will be safe, even at today's high levels. Right now it does not look as if Japan is going to check the deflation. Last month Japan elected a new prime minister, Keizo Obuchi, who appointed 78-year-old Kiichi Miyazawa as finance minister. Miyazawa has already tipped his hand that he intends to attack the Japanese economy in the same futile way his predecessors have done: with fiscal stimulus. But consumer and corporate tax cuts are not going to solve Japan's problems. The country needs aggressive monetary expansion, and until that happens Japan's problems will continue—and so will our good luck.

How high should multiples be? The current ten-year Treasury bond yield of 5.5% implies an aftertax cost of equity capital of 9.06% for the S&P 500. Return on equity is just under 20%, and growth is running about 6.5%. My colleagues Deborah Allen and Paul Davis have estimated that at these levels the intrinsic value of the S&P 500 index today, i.e., the present value of its free cash flows, implies a P/E of 26 to 28.

So, assuming that Japan remains mired in deflation, the chief risk in the U.S. stock market is unrealistic earnings expectations. For more than a decade, U.S. companies have reported that earnings were growing faster than sales, but this era is ending. Tight labor markets in the U.S. mean that employers are no longer able to increase earnings by firing people or reducing their pay. And the restructuring story has run its course. This means earnings will grow at about the same rate as sales, or 5% per year.

From now on companies are going to have to earn their profit growth the old-fashioned way, by selling more products to customers. Unfortunately, we have trained an entire generation of managers to make money by firing people and restructuring balance sheets. There is a shortage of broadly trained operating managers good at product development and marketing rather than cost-cutting. These managers will become increasingly valuable in the next phase of the bull market.

Five percent earnings growth doesn't mean the stock market is going to fall apart. It means that investors can no longer count on index funds. Old-fashioned stock pickers who know a company cold before they buy it are going to enjoy this market.