(January 22 – 09:30 ET) – “After a miserable year in stocks and the bursting of the Nasdaq bubble, much of the new-era thinking once used to justify unprecedented valuations has been disgraced,” writes Greg Ip in today’s Wall Street Journal.

“Investors who had believed the old rules of the market didn’t apply have learned to their chagrin that the most dangerous words on Wall Street are, ‘It’s different this time.’ “

“Well, if it isn’t any different this time, then stocks could have more trouble ahead, despite the gains of the past week. Consider this: For the past 50 or so years, the Standard & Poor’s 500-stock index has traded at an average of 14 times earnings. That suggests that at its current valuation of almost 24 times trailing earnings, the S&P would have to fall 40% to return to historic norms.”

“But in fact, some things are different this time. They’re not all comforting, but they should be kept in mind by investors tempted to rush from excess optimism to despair.”

“Last week, the stock market continued its attempts to dig out from last year’s hole. The S&P 500 rose 24 points, or 1.8%, to 1342.54, but it remains 12% below its high of last March. The Dow Jones Industrial Average rose 62.21 points, or 0.6%, to 10587.59, still down 10% from its high of a year ago. The Nasdaq Composite Index rallied, and finished the week up 12.1% for 2001 so far — but is still 45% off its high.”

“Ben Inker, head of asset allocation at Boston money manager Grantham, Mayo, Van Otterloo & Co., believes that the broad market is steeply overvalued, but also thinks enough has changed to suggest that its valuations need not fall to their historic average. A less-volatile economy and better-run monetary and fiscal policy mean ‘people are more comfortable with equities, and we think that’s a permanent change,’ he says.”

“Consider that average price/earnings ratio of 14 for the S&P 500: It includes periods when stocks traded at seven times earnings, such as the mid-1970s and early 1980s — when inflation was high and the economy in recession. And it includes periods when they traded at more than 28 times earnings, as they did in 1999 and early last year when inflation was low and the economy booming.”

“Most analysts agree lower inflation deserves higher P/Es because it produces lower interest rates. Those lower rates, in turn, raise the present, discounted value of future profits. Low inflation also reduces accounting distortions in profits. Right now, inflation looks low: The ‘core’ inflation rate — which excludes the volatile food and energy components — was just 2.6% in December, well below the 4.4% it has averaged since 1957.”