Inflation Illusion and Stock Prices

Author(s): John Y. Campbell and Tuomo Vuolteenaho

Source: The American Economic Review , May, 2004, Vol. 94, No. 2, Papers and
Proceedings of the One Hundred Sixteenth Annual Meeting of the American Economic
Association San Diego, CA, January 3-5, 2004 (May, 2004), pp. 19-23
Published by: American Economic Association

Stable URL: https://www.jstor.org/stable/3592850

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 Inflation Illusion and Stock Prices

By JOHN Y. CAMPBELL AND TUOMO VUOLTEENAHO*

The influence of the macroeconomy on the (CAPM) betas. Asness (2000, 2003) obtains
stock market is a subject of enduring impor-even higher R2 values with slightly different
tance and fascination to academics, investment
specifications.
professionals, and monetary policymakers. Ac-Figure 1 illustrates the fit of this regression.
ademics have devoted much of their effort to Much of the volatile movement of the dividend-
models that link stock prices to consumption price ratio during the 1930's and 1940's was
through the first-order conditions of individual related to the cross-sectional equity risk pre-
investors. In contrast, most investment profes- mium. At the bottom of the Great Depression,
sionals have adopted a radically different per- this explained the high level of the dividend-
spective. The leading practitioner model ofprice ratio despite deflation supporting stock
equity valuation, the so-called "Fed model,"prices. As inflation rose during the late 1930's
relates the yield on stocks (as measured by the and 1940's, its negative influence on stock
ratio of dividends or earnings to stock prices) to prices was outweighed by the positive influence
the yield on nominal Treasury bonds, often withof the declining risk premium. In the postwar
an adjustment for the relative risk on stocks andperiod, the cross-sectional risk premium gener-
bonds.' The idea is that stocks and bonds com- ally trended downward, stabilizing at a low
pete for space in investors' portfolios. If thelevel in the early 1980's. Inflation rose steadily
yield on bonds rises, then the risk-adjusted yieldduring the 1960's and 1970's, accounting for
on stocks must also rise to maintain the com- the depressed stock prices of the early 1980's.
petitiveness of stocks. During the later 1980's and 1990's, the dividend-
Historically, the major influence on nominal price ratio was driven downward by declining
bond yields has been the rate of inflation. Thus inflation.
the Fed model implies that stock yields are
highly correlated with inflation. In the late I. Interpreting the Relation between Stock
1990's practitioners often argued that falling Prices and Inflation

stock yields, and rising stock prices, were jus-

tified by declining inflation. Despite the empirical success of the Fed
As pointed out by Clifford Asness (2000, model as a behavioral description of stock
2003), the Fed model has been quite successful prices, there is a serious difficulty with this
as an empirical description of stock prices. In model as a rational explanation of stock prices
Campbell and Tuomo Vuolteenaho (2004), (Franco Modigliani and Richard Cohn, 1979;
we explain 49 percent of the variation in the Jay Ritter and Richard Warr, 2002; Asness,
dividend-price ratio using the historical infla- 2003). To understand the difficulty, consider the
tion rate and an estimate of the equity risk classic "Gordon growth model" (John Burr
premium, obtained by Christopher Polk et al. Williams, 1938; Myron Gordon, 1962) which
(2003) from the cross section of stock prices as expresses the dividend-price ratio in steady
the rank-order correlation of stock-level yield state as

measures with capital asset pricing model

D,
(1) =R-G
Pt- I
* Department of Economics, Littauer Center, Harvard
University, Cambridge, MA 02138, and NBER. We thank where R is the long-term discoun
Cliff Asness for his helpful comments. This material is the long-term growth rate of div
based upon work supported by the National Science Foun-
dation under Grant No. 0214061 to Campbell.
model argues that the discount r
Despite this name, the model has no official or special the yield on bonds plus a prox
status within the Federal Reserve system. premium of stocks over bonds.
19

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 20 AEA PAPERS AND PROCEEDINGS MAY 2004

damages the real economy, and particularly the

profitability of the corporate sector. In this case
real G might fall when inflation rises, justifiably
* }
.s driving up the dividend-price ratio. A second
__ 0.03
.u
' hr
possibility is that inflation makes the economy
riskier or investors more risk-averse, driving up
the equity premium and thus the real discount
au 0.01 rate R.

Q 0 Modigliani and Cohn (1979) propose a more

-0.01
radical third hypothesis, that stock market in-
I
vestors fail to understand the effect of inflation
-0.02
on nominal dividend growth rates and extrapo-
-0.03
I I I I I I
late historical nominal growth rates even in
1927 1937 1947 1957 1967 1977 1987 1997 periods of changing inflation. Thus when infla-
Year
tion rises, bond-market participants increase
FIGURE 1. DIVIDEND YIELD, EQUITY RISK PREMIUM, nominal interest rates which are used by stock-
AND INFLATION market participants to discount unchanged ex-
Notes: The de-meaned dividend yield on the S&P 500 indexpectations of future nominal dividends. The
is marked with triangles, the de-meaned cross-sectional dividend-price ratio moves with the nominal
equity risk premium is marked with a solid line, and de-bond yield because stock-market investors irra-
meaned smoothed inflation is marked with a dashed line.
tionally fail to adjust the nominal growth rate G
The cross-sectional equity risk premium and inflation are
to match the nominal discount rate R. From the
multiplied by their respective multiple regression coeffi-
cients in the regression of dividend yield on the cross-perspective of a rational investor, this implies
sectional equity risk premium and inflation. that stock prices are undervalued when inflation
is high and overvalued when it is low.
ables will explain the movement in stock prices In this paper we try to distinguish among
if G is constant. these three alternative views. To understand our
The problem with this interpretation is that approach, it is helpful to return to the simple
the main influence on the long-term nominal Gordon growth model and subtract the riskless
interest rate is the expected long-term rate of interest rate from both the discount rate and the
inflation (Eugene Fama, 1975, 1990; Frederic growth rate of dividends. We define the excess
Mishkin, 1990a, b). The long-term real interest discount rate as Re - R - Rf and the excess
rate is comparatively stable and does not move dividend growth rate as Ge - G - Rf. We are
closely with the long-term nominal rate. In real considering the possibility that some investors
terms, neither R nor G should change with ex- are irrational, so we must distinguish between
pected inflation. While the Gordon growth the subjective expectations of irrational inves-
model can be written in nominal terms, this tors and the objective expectations of rational
requires that dividend growth G is measured in investors. As long as irrational investors simply
nominal terms. Since stocks are claims to the use the present-value formula with an erroneous
productive capital of the real economy, one expected growth rate, both sets of expectations
would expect that a change in long-term must ex- obey the accounting identity of the Gor-
pected inflation would move nominal G one- don growth model. Thus we have
for-one, offsetting the effect on nominal R and
leaving the dividend-price ratio unaffected. The
(2) = Re,OBJ _ Ge,OBJ = Re,SUBJ - Ge,SUBJ
conventional interpretation of the Fed model
implicitly compares apples to oranges, a point
made forcefully by Asness (2003). _ Ge,OBJ Re,SUBJ + (Ge,OBJ -_ e,SUBJ).
If the above conventional argument does not
explain the empirical relation between stock In words, the dividend yield has three compo-
prices and inflation, what does explain this nents:
re- (i) the negative of objectively expected
lation? One possibility is that inflation (or theexcess dividend growth, (ii) the subjective risk
monetary authority's response to inflation) premium, and (iii) a mispricing term that is due

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VOL. 94 NO. 2 ASSET BUBBLES AND THE MACROECONOMY 21

to a divergence between the objective and sub-TABLE 1-REGRESSIONS OF DIVIDEND YIELD'S

COMPONENTS ON INFLATION
jective growth forecasts.
The first step in our analysis is to show that
Dependent Coefficient
Ge,OBJ = Re,OBJ - DIP tends to rise, not fall,
variable on r, R2 (percent)
and that Re'SUBJ tends to fall, not rise, with
dy, 4.01 7.19
inflation, thus ruling out the rational justifica- (6.02) (14.48)
tions for the co-movement of the dividend yield
-E EAde -11.25 94.78
with inflation. The second step is to show that, (6.35) (33.46)
+yA, -1.58 6.61
consistent with the Modigliani-Cohn view, high
(3.85) (15.42)
inflation coincides with underpricing caused by
+e, 16.83 77.90
a positive divergence between objective and (6.78) (27.07)
subjective growth expectations.
Notes: We use a VAR model to dec
II. Empirical Implementation and Resultslog dividend yield, dy,, into thr
negative of long-run expected d
E BJAd'i, where Adt+l is the de-m
To allow for time-varying discount rates,growth;
we (ii) the subjective risk-pre
use the log-linear dynamic valuation framework
and (iii) the mispricing component,
of Campbell and Robert Shiller (1988): simple regression coefficients of log
three components on smoothed infla
sponding regression R2 values. Sta
k theses) are computed from 10,000
(3) d,_-Pt- pl estimated VAR.

oc oc

and the sensitivity of our results to changes in

+ E
the VAR specification. pi
j=0 j=0
We first estimate the term EJ=o pJEtBJrt+j
under objective expectations using the VAR
where Ad and then infer the objective
denotes log expected growth
divi
notes log rate -EJ =o pJEOBJAdtj
stock return, using equation (3).
A
log risk-freeThe subjective
rate risk premium
for is estimated
the as the
r less the fitted value
log (yAt) of a regression of EJ=o
risk-free ra
(-0.97) and k
pjE are
tlrt+j constan
on the subjective risk-premium
paring proxy At. Mispricing,
equations (2)or the difference
and between
(3
analogous objective
to and subjective expectedand
ReOBJ dividend
Adt+j is growth, is the residual se of this
analogous to regression.
Ge
pending on When stocks are subjectively perceived
whether the to be e
objective orvery
subjective.
risky, then the fitted value yAt is high. In
Following contrast, when stocks are underpriced(199
Campbell the resid-
valuation ual s, is high. Together these three
framework withseries,
sion (VAR) -Ethat predicts
o pJE?BJ Adej, yA,, and et, add up to log
first-order dividend
VAR yield. includes
on the S&P 500 index over the three-month Table 1 shows our VAR results. The central
Treasury bill (r6), the cross-sectional equity prediction
risk of the Modigliani-Cohn (1979) hy-
premium of Polk et al. (2003) (A), the log pothesis is that high inflation leads to stock-
market underpricing and low (or negative)
dividend-price ratio (dy), and the exponentially
smoothed moving average of inflation (ir).inflation
The leads to overpricing. The main com-
sample period for the dependent variables is hypotheses are that low stock prices co-
peting
June 1927-December 2002, and the sample inciding
thus with high inflation are rationally
consists of 303 quarterly data points. See justified because high inflation coincides with
Campbell and Vuolteenaho (2004) for details low
ofexpected dividend growth or a high subjec-
the data, the VAR parameter estimates,tive therisk premium. To examine these hypothe-
methodology to compute the standard errors, ses, we regress the three components of

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22 AEA PAPERS AND PROCEEDINGS MAY 2004

The Modigliani-Cohn hypothesis has inter-

esting implications both for investors
and for
monetary policymakers. Investors need to know
whether stocks, as real assets, provide a hedge
co
against inflation. Fama and G. William Schwert

i '-w '. h
(1977) and others have documented the nega-
tive effect of inflation shocks on realized stock
1o.5
returns. The Modigliani-Cohn hypothesis ex-
plains this as the result of mispricing driven by
inflation illusion, an effect which should dimin-
ish over the longer run. Jacob Boudoukh and
Matthew Richardson (1993) examine this issue
-2.0 directly and find that stocks are better inflation
1927 1937 1947 1957 1967 1977 1987 1997
Year hedges over five-year periods than over one-
year periods.
FIGURE 2. MISPRICING AND INFLATION There has also been an active recent debate
Notes: This figure plots the time series of two variables: (i) about whether monetary policy should be used to
The mispricing component of log dividend yield, markedcombat stock-market mispricing. The Modigliani-
with circles; and (ii) the fitted value from a regression of
Cohn hypothesis suggests that disinflation may
mispricing component on inflation, marked with a line.
High mispricing indicates undervaluation, and low mispric- itself generate mispricing
by confusing stock-
ing overvaluation of stocks. market investors who are
subject to inflation
illusion. It also implies that a successful stabi-
lization of inflation will reduce the volatility of
dividend yield on inflation. The regression co- mispricing and thereby contribute to the effi-
efficient of - 0 pE PtBAd't+j on inflation isciency of the stock market.
-11.25 with an R2 of 95 percent, implying a
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VOL. 94 NO. 2 ASSET BUBBLES AND TI YE MACROECONOMY 23

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