Interest rates and inflation have a much greater role in stock market valuations than you might think, and that means the stock market is on a “very dangerous” path, according to Rob Arnott.

In an article for Morningstar, Arnott, of Research Affiliates and PIMCO, looks at the relationship between stock market valuation levels, interest rates, and inflation. His findings: More than half the variability in P/E ratios over the past 140 years can be explained by changes in real interest rates and inflation. “Modest — or even moderate — inflation seems to have a benign impact on valuation multiples. Modest — or even moderate — positive real interest rates seem to have similarly benign consequences. Indeed, with real rates and inflation ranging from 1–5%, the average Shiller P/E ratio hovers around 22 times 10-year smoothed earnings, give or take a mere 15%.” But, he adds, “P/E ratios fall off a cliff outside of this range.”

Currently, the Shiller P/E (which averages earnings over the past ten years) is around 20. Trailing three-year inflation is about 1% per annum, and the 10-year Treasury bond yields about 2.0%, meaning that the “real yield” is about 1%. Historically, when inflation and real yields are both in the 1–3% range, the Shiller P/E averages about 19, Arnott says, so the current level is only slightly higher. “But,” Arnott says, “this arithmetic misses something important: radical changes in the way the federal government calculates the Consumer Price Index.” Official data shows that the current inflation rate is about 3% to 4% lower than it would be using the old method, he says. Using a more conservative estimate of a 2% difference, history suggests the Shiller P/E should be about 18 right now. And, importantly, the market gets closer to falling off the edge of its “valuation sweet spot”.

And it could soon fall off that edge. In the next six months, Arnott says, “the deflation from late 2008 will … drop out of our three-year [CPI] rates. CPI is up by 7% over the past 30 months, which works out to 2.3% per year. If we add our 2% adjustment to create more of an apples-to-apples comparison with history, ‘true’ inflation is above 4% and the ‘true’ real interest rate is very low, around  -2%. At these levels, the normal Shiller P/E ratio would be 13 times our 10-year average earnings, which takes us below 800 on the S&P 500 Index.”

Arnott says he’s not saying that will happen in the next year. “We’re merely pointing out that the path we’re on — low or negative real interest rates, with a conscious attempt to introduce moderate levels of inflation — is very dangerous,” he says. “While low interest rates are fueling higher stock market multiples, this policy may haunt investors in the years ahead.”