By the time NASDAQ reached its peak in the recent bull market, many financial commentators had begun to accept the idea that stock market valuations were no longer driven solely by the traditional economic factors: earnings growth, inflation, and interest rates. Instead, they suggested, new factors—such as structural changes in the economy, new rules of economics, and the value of intangible assets and brands—justified the lofty stock prices. Today those valuations seem ludicrous, though the fundamental question remains: has the market changed what it factors into share values? Using a simple model based on changes in earnings, inflation, and interest rates, we found that the traditional factors alone explain most of the medium- and long-term movement in the S&P index of 500 stocks over the past 40 years. We uncovered scant evidence that the market had changed the things it consistently factored into stock prices.

This reality doesn’t mean that the market never deviates from fundamental values: a strong case can be made that the performance of Internet and high-technology stocks during the second half of the 1990s added up to a "bubble." But such deviations tend to be short-lived. The economy and the market are closely connected, making...