Crestmont Research, a research group that promotes hedge fund investing, notes:
"Conventional stock market wisdom has promoted a fundamental relationship between P/E ratios and interest rates. It relied upon a key assumption that inflation was positive—that deflation was not a possibility. As reflected in this chart, P/E ratios increase when inflation trends toward price stability (near 1% inflation) and P/E ratios decline when inflation trends away from price stability. The result is a "Y Curve" effect; where P/E decline into deflation despite low interest rates. This is consistent with the modern 'dividend discount model' since earnings and dividends would be expected to decline during deflation and therefore would result in lower valuations."
A quote in the recent newsletter from Investment Quality Trends may summarize the situation the best:
"To some market valuations are hostile. To others, market valuations offer opportunity. We will leave the discussion about the market valuations to others because we don't know how to value markets; we do know how to value stocks."