Reportgreen2004

Inflation Illusion and Stock Prices

76 citations0/0 files storedNational Bureau of Economic Research

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Financial Markets and Investment Strategies Monetary Policy and Economic Impact Financial Analysis and Corporate Governance

Abstract

We empirically decompose the S&P 500's dividend yield into (1) a rational forecast of long-run real dividend growth, (2) the subjectively expected risk premium, and (3) residual mispricing attributed to the market's forecast of dividend growth deviating from the rational forecast.Modigliani and Cohn's (1979) hypothesis and the persistent use of the "Fed model" by Wall Street suggest that the stock market incorrectly extrapolates past nominal growth rates without taking into account the impact of time-varying inflation.Consistent with the Modigliani-Cohn hypothesis, we find that the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.

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References

1988The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors 1977Asset returns and inflation 1990A VARIANCE DECOMPOSITION FOR STOCK RETURNS 1983The Fiscal and Monetary Linkage Between Stock Returns and Inflation 1963The Investment, Financing, and Valuation of the Corporation 1979Inflation, Rational Valuation and the Market 1993What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns 2021Short- Term Interest Rates as Predictors of Inflation

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