Inflation Flow-Through and Stock Prices

Abstract

Fund of the City College. he well-documented negative relationship 'between inflation and stock returns has been the subject of extensive research activity. Several hypotheses have been advanced to explain the puzzling adverse effect of inflation on the stock market. The major ones are the taxation-system hypothesis of Feldstein [ 19801, the financial dependence hypothesis of Lintner [ 19751, the proxy effect hypothesis of Fama [1981 and 19821, the signaling hypothesis of Geske and Roll [1983], and the nominal contracting hypothesis of French, Ruback, and Schwert [1983]. While empirical studies at the aggregate market level abound (one is Fama and Schwert [1977]), empirical investigation at the disaggregated level has been sparse. Bernard [ 19861 tests several prominent hypotheses using data at the firm and industry levels. Ma and Ellis [1989] explore the micro-level characteristics that enable some industries to be better inflation hedges than others. Our objective here is to investigate the relationship between inflation and stock prices at the industry level for the U.S. economy, using the flow-through constant hypothesis of Estep and Hanson [1980]. In this hypothesis, the flow-through constant represents the fraction of inflation that flows through to profit growth and plays a key role in determining the sensitivity of the stock value to changes in inflation. Specifically, the negative effect of a rise in inflation on a firm's share price will be inversely related to its flowthrough ability. The empirical evidence we present strongly suggests the presence of a flow-through effect in equity valuation. We demonstrate that 1) estimated flow-

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