Are Equity Investors Fooled by Inflation?

Stock prices are undervalued when inflation is high, and can become overvalued when inflation falls.

When examining the links between the U.S. economy and the stock market, many investment professionals rely on what is known as the "Fed model." The model assumes that bonds and equities compete for space in investment portfolios; if bond yields increase, then stock yields must also rise in order to remain competitive. Thus, the Fed model relates the yield on stocks (as measured by the ratio of dividends or earnings to stock prices) to the yield on Treasury bonds and to the relative risk premium of stocks versus bonds. The bond yield plus the risk premium equals a "normal" stock yield; over time, the Fed model posits, the actual yield on stocks will revert to this normal yield. In other words, if the actual stock yield exceeds the normal yield, then stocks are attractively priced. If the actual yield falls short of the normal yield, then stocks are overpriced.

Historically, the rate of inflation has been a major influence on nominal bond yields. Therefore, the Fed model implies that stock yields and inflation must be highly correlated. Indeed, in the late 1990s, investment practitioners argued that declining stock yields -- and rising stock prices -- were justified by declining inflation. In Inflation Illusion and Stock Prices (NBER Working Paper No. 10263), authors John Campbell and Tuomo Vuolteenaho explore this link and evaluate the empirical performance of the Fed model over time.

Campbell and Vuolteenaho review stock market performance between 1927 and 2002, examining the impact of risk premiums and inflation on stock yields. They find that much of the volatility of the stock yield during the 1930s and 1940s was related to the volatility of the risk premium. As inflation increased during the late 1930s and into the 1940s, the declining risk premium outweighed the dampening influence of rising inflation on stock prices. After World War II, the risk premium trended downward; but inflation rose steadily during the 1960s and 1970s, accounting for the depressed stock prices of the early 1980s. Finally, during the late 1980s and 1990s, part of the explanation for high stock prices can be found in the era's declining equity premium and declining inflation rate.

The historical influence of inflation on stock prices is mysterious because stocks are claims to the profits generated by the corporate capital stock, and thus are real assets that should not be directly vulnerable to inflation. Why then does inflation seem to be so important for the stock market?

The authors consider three answers. First, inflation -- or the central bank's response to inflation -- damages the real economy and by extension the profitability of corporations. Second, inflation might make investors more risk-averse, thus driving up the risk premium. A third and more radical explanation is the one proffered by the late Franco Modigliani and Richard Cohn in a 1979 paper. Modigliani and Cohn contend that stock investors -- and not their bond counterparts -- are subject to "inflation illusion;" that is, they fail to understand the impact of inflation on nominal dividend growth rates and extrapolate historical nominal growth rates even in periods of changing inflation. From a rational investor's viewpoint, then, stock prices are undervalued when inflation is high, and can become overvalued when inflation falls.

Using the S&P 500's dividend yield and regression analysis, the authors find the first two explanations lacking. High inflation is positively correlated with rationally expected long-run dividend growth. Therefore, inflation's negative effect cannot be explained through that channel, and inflation is largely uncorrelated with the subjective risk premium. Inflation is highly correlated with mispricing, however, supporting the Modigliani-Cohn argument that investors form subjective growth forecasts without taking inflation into account.

The Modigliani-Cohn hypothesis offers useful insights for investors and policymakers alike, the authors conclude. Investors need to know whether equities can serve as a hedge against inflation. "The Modigliani-Cohn hypothesis," write Campbell and Vuolteenaho, "suggests that disinflation may itself generate mispricing by confusing stock market investors who are subject to inflation illusion." Moreover, they explain, Modigliani-Cohn implies that stable inflation will reduce mispricing and thereby foster a more efficient stock market.

-- Carlos Lozada