Lessard WP 114C70 October 1980

University of Illinois at Chicago Circle and Massachusetts Institute of Technology, respectively. The authors have received helpful comments from a large number of individuals in the course of this study. Particular thanks are expressed to Franco Modigliani. The rather heterodox views presented in this paper are to be ascribed solely to the authors, however; they alone bear responsibility. They express grateful appreciation to Nancy Davidheiser, Roy Henriksson, Geoffrey Ward, and Kwame Yeboah for their able research assistance. Paper presented at the September 1980 meetings of the American Economic and American Finance Associations in Denver, Colorado.



1. I. Introduction The last decade has been characterized by historically high rates of inflation virtually the world over. economists stock have been the effects This paper Of particular concern to financial corporate profits and

of inflation on a consistent



investigation of these

effects for the United States and for a number of other countries over this period. While the nature of hypothesis testing in finance is such that the always be out, the results would seem to suggest that money national security

jury must

illusion may characterize valuation market.

in more

than one

The plan of the paper is as follows. selective review of the relevant

Section II provides a brief, and correlation evidence.


Section III provides regression evidence and Section IV a summary.

II. A.

Stock Prices and Inflation: Review of the Literature

Prior Work

Bodie [1) found that in the United States during the period 1953-1972, common stocks failed to serve as hedges against either anticipated or

unanticipated inflation.

These perhaps surprising results (common stocks 17,

are claims on real assets) are consistent with those of Reilly et al. Lintner [12], [7]. Jaffeand Mandel;er [9], and Cagan Nelson [16],

and Fama and Schwert

Branch [2]

3] present findings from a number of foreign of stock prices to keep up with restricted to the United

countries which suggest that the inability the general price level is not a


States. B. The Modigliani-Cohn Hypothesis In an attempt to explain the anomalous failure of common stocks to perform as inflation hedges in the United States during the post-1952

period, Modigliani and Cohn [14) examined the valuation of common stocks in


----- -

of true earnings as a function of interest and inflation rates.2. earnings yields (latest twelve months' earnings/current price). Relationships Between Stock Prices and Inflation in Other Countries. C. in a period of inflation." or long-run. a careful study of this phenomenon requires adjusting for these effects. . Table I shows the correlations of stock prices. error was failure to realize that. They found that inflation had a negative effect on value given the effect of inflation on profits. It focuses on the valuation of equity in relation to a earnings. This paper seeks to examine whether evidence of market behavior in other countries is consistent with the Modigliani-Cohn hypothesis for the United States. part of interest expense is not truly an expense but rather a repayment of real principal.1 Anomalous (positive. and they inferred that their findings resulted One from two a continuing valuation errors committed by the market. relation to an estimate of "noise-free. explicitly attempting to control for the measure of noise-free effects of real economic factors on share values over the period studied. The second and more serious error was the capitalization of long-run profits. since price is in the denominator) relationships hold for earnings and dividend yields for most countries as well. Negative correlations between stock prices and inflation or nominal interest rates are characteristic of most major industrialized countries. not at a real rate but rather at a rate that varied with nominal interest rates. a real variable. given that reported earnings themselves are biased estimates However. and dividend yields (latest twelve months' dividend/current price) with long-term interest rates and inflation in the eight largest countries by stock market capitalization for the 1970 to 1979 period. 1 Sources of data are discussed below in Section III-B. profits.

A.K. 44* -. a% change in CPI over past year.03 -.16 -.67* . 82* France Germ any -.16 -. and Dividend Yields with Quarterly Cbservations 1970-1979 Long-term Interest Rates and Inflation -- In fl ationa Stock Price Earnings Yield .3.S.86* .81 * Div idend Yield .73* Canada Interest Rate In fl ation Interest Rate In fl ation Interest Rate In fl ation Interest Rate In fl ation Interest Rate Infl ation Interest Rate Infl ation Interest Rate In fl ation Interest Rate In fl ation · 74* .19 .58* -.53' .73* . 46' -. 26 -. presents information about cash earnings for Italy. 25 -.16 .26 .77* . 60* U.88' .63* -. III. P kWe can view the valuation process in the following manner: k-eg'' E (1) -. Earnings Yields.31 -.I---I-------------- . 25 .87* Netherlands U.88' .05 level.67 -. Table I Correlations of Stock Prices.13 .51* Italy Japan . 06 .83* ·84* .46* .03 .42* c .01 . -.46* . 24 -.12 -.76* .55* . Significant at the .68' . 02 .77* . it does not provide data on earnings.17 -. b 1 9 7 1 :3 to 1979:4 While Capital International Perspective [4] CPrice to cash earnings.78* .73* . 58* -.30 b . 09 . 62* --54* -.82* .62* .17 . Model Specification and Estimation Regression Specification The basic regression specification that we adopted in order to try to test the Modigliani-Cohn hypothesis for our sample countries is similar to that in 14].

earnings dividends.pd.4. p + (p-r) d. is (2) an attempt to explain that the focus of our investigation as P/E rather than I . that is. and eg a term that reflects the present value of the firm's true growth opportunities. Invoking to Modigliani-Miller 15] (3) k is equal and assuming neutral taxation.d]. where A = a (1+d) and B = b (1+d) .2 k the market's required real rate of return. would is be expected by The true growth rate. r the real rate of interest and d the firm's target debt-equity ratio. In order to develop a test equation amenable to regression analysis. we rewrote (2) ln (P/E) = -ln (k . k can be expressed as k = A + B (R-p). a concept discussed below. In the no-growth case e would be zero. where p represents the unlevered cost of equity. then the capitalization rate would be k . By "true" growth is meant anticipated real growth in earnings per share resulting rate of return greater than k rather from opportunities to invest at a than simply fran the investment of retained earnings at the rate k. rate of interest. 2If E is partially adjusted noise-free .ln (k g). and represented coefficient designed reflect the length of time such true growth is expected to persist. Letting p represent the long-run anticipated be written as a + br rate of inflation and noting that p can where R is the long-term nominal 14] and r as R-p. E the contemporaneous level of noise-free expected earnings. we took logarithms of both sides of (1). obtaining ln P = To emphasize n E . where P represents the fully adjusted price of a share. and in the extreme case of perpetual growth 8 would be equal to unity. the rate at which if the all earnings were 8 is paid out as to to grow g. fully adjusted noise-free earnings less the debt adjustment. where p is defined below as the long-term anticipated rate of inflation and d as the firm's target debt-equity ratio.

and can be approximated as reasonable to presume that B(R-p) - g is therefore the second right-hand-side term of (6) (R-p) g A -kg. multiplying employment. E by an exponential function of labor force to the labor force to employment. The a5 term.~~~~ ~ ~ ~ ---~ ~ ~ "l~~~~~~~~~~l~~. A Taking advantage of this approximation. it can be reasonably hypothesized that investors. in (k-eg) = It is n A + n (1 +B (R-p) A -g) (5) (6) small in relation to A. and adjust from actual of earnings from cyclically periods upward periods above-normal activity downward. defined as the percentage increase in 3It becomes k adjusted E. in essence. °+ a 1 Rt + a2ZwTp (t-T) + a 3 PRE t + a 4 gt + a5w LF/Emp (t-T)6+ a (DIV/E)t+ u t .-~~~I ~ ~ ~ . the ratio of was designed to capture this cyclical effect by.6 Taking logarithmns of both sides of (5). Thus the capitalization rate for earnings becomes k g = A + B (R-p) = A (1 + B (R-p) .---. (8) The last two independent variables represent an attempt to improve upon our estimate of E by trying to capture the effect of the business cycle on actual earnings and also the "information content" of dividends.---- . a distributed lag of LF/Elp. DIV/E. 3 (4) and can be rewritten as k . in assessing the information content of past earnings in forming expectations depressed of long-run earnings. can be rewritten as (7) Our basic test equation. g - pd = A + BR - (B+d)p - g in the case of partially " ·· ··. (3) in (P/E) = -ln A R + B p + is g.5. in (P/E)t = a based on (7). With respect to the business cycle. The a 6 term.

rational valuation would imply a positive value for a and a negative value for a1 Rational since R = r + p and the coefficient of r should be negative. eight-quarter average deviation in the labor force unemployment rate from the eight-quarter mean. the coefficient of the inflation term should be greater in absolute value than a1 so as to reflect the fact that partially adjusted E falls as p rises. was designed to capture systematic changes over It was measured as a moving time in the market's required risk premium. 4 Our measure of R was the same as that which we used in estimating the correlation coefficients in Section II. The coefficients of the If expected earnings are developed as E(Current payout/Average payout). Our estimate of the long-run the source of which is discussed rate of inflation was a expected distributed index. 6If E is only partially adjusted. PREM. represented an attempt to capture the dividend information content notion. . Assuming that the relevant variables are measured correctly. then the logarithm of expected earnings can be viewed as ln E + ln(Current payout/Average payout) . current dividend payout ratio over the average of that of the current year and that of the immediately preceding one. 5 We have no a priori notion as to the normal unemployment rate for the countries in question and were reluctant to assume that the normal rate was not subject to change. to An lend coefficient of p would tend support to the Modigliani-Cohn hypothesis that the capitalization rate is directly related to the nominal interest rate. lag of past rates of change in the national consumer price The a3 term. The logarithm of (Current payout/Average payout) is approximately DIV/E. 5 The growth term was estimated growth rate as an eight-quarter annualized trend in the national index of industrial production. below.6. The u term represents the residual. a1. valuation implies that the coefficient of the p term should be equal in absolute value algebraically but opposite in lower value for sign the to that of the R term.

it would appear that in valuing shares. According to Modigliani and Cohn's findings for the U. growth. reported earnings computed according to generally accepted accounting principles in the U. 7 Capital International reports for each country a stock price index. and dividend payout terms should be positive while that of the risk premium term should be negative. hence.S. [4] on a quarterly basis for the The data for each country are capitalization-weighted aggregates of the relevant data for individual firms listed on the major domestic stock exchanges and. dividends and depreciation were derived from these ratios.S. business cycle. earnings. an aggregate price to cash earnings (earnings plus depreciation) ratio. With inflation. and depreciation data were obtained from Capital International Perspective period 1969 to 1979. Sources of Data Stock price. a premium which should be viewed as a repayment of real principal rather than interest.7.7 C. and a dividend yield. 2) the potential understatement of the cost of goods sold when there is a significant lag between the purchase of inputs and the sale of finished goods and 3) the overstatement of financial charges by the extent to which nominal interest rates reflect a premium for anticipated inflation. an aggregate price to earnings ratio. are representative of the corporate sector as a whole. B. Adjustments to Earnings The Modigliani-Cohn hypothesis requires a test of the impact of inflation on the ratio of stock prices to "noise-free" long-run earnings. ·___·_IX ^-VII·l(l·-(······i-·····ll··-- . This is reassuring since data on certain other variables were available only for the entire corporate sector and were incorporated with appropriate proportional transformations. are biased estimates of "true" earnings. The principal sources of bias are 1) the understatement of depreciation relative to actual capital consumption. investors make the necessary adjustments for two of these effects. Only stock price data are available before 1969. Earnings. dividend..

a sample that differs from the one for which we have price. Depreciation Adjustment (CC): With inflation. often However. the 8 The adjustments for inflation biases required data available only for the entire non-financial corporate sectors of each country. In depreciation and cost of goods sold. thus. the two principal components of corporate investment. it will affect the required inflation adjustment. computing book depreciation was inferred from a comparison of the ratio of book depreciation to the stock of depreciable fixed assets for the nonfinancial corporation sector in each country relative to a true ratio computed from the age and composition of the capital stock of each country. Data on book depreciation relative to the stock of depreciable fixed assets were obtained from OECD Financial Statistics 17]. the asset life used in computing book depreciation is than economic life. earnings. should closely match the Annual additions to non-residential structures and entire economy. stock dating from a given year should not be too great since our indexes are weighted by market capitalizations and. differences in the proportions of capital depreciation data. and hence a positive inventory used. but fail to make the examining it must the be impact of inflation that not on stock may prices the in other countries. machinery. but the extent to which investors make these adjustments may differ as well. Assuming FIFO accounting.111 8. whereas (LIFO) is used. understated third. 8 Inventory Adjustment (INV): The second impact of inflation on reported earnings is the understatement of the cost of goods sold when there is a lag between the purchase or production of goods and their sales. the bias is stock. it usually is insignificant. were obtained from the UN Yearbook of National Income Accounts [22] as were the The asset life used in implicit defla tors for both classes of assets. and book However. . recognized only adjustments necessary to remove inflation-induced biases in reported earnings differ across countries. Although in the steady state this shorter difference in lives would not affect depreciation charges. If first in-first out (FIFO) accounting is if last in-first out accounting substantial. historical cost depreciation understates economic depreciation as a function of the age and composition of the capital stock and cumulative inflation for level of each category of assets.

we used secondary market yields to maturity on medium to long-term bonds from OECD Financial Statistics 17] for the period 1969:1 to 1972:4 and from Morgan Guaranty Trust Company's World Financial Markets [23] for 1973:1 to 1979:4. "YtlB9( Dmllil --. Tax on interest income in Italy is usually withheld at the source. always measured for the previous twelve months. This inventory figure was transformed into a figure appropriate to our sample by first taking a ratio of inventory to depreciation for the OECD sample and then multiplying it by depreciation for our sample. full 1969-79 period (r) was estimated as the average difference over the values price of R and Our annualized estimated between in end-of-quarter the consumer quarterly rates of change index.9.12 9 Estimates of the size of inventory holdings were derived from balance sheet and income statement data for national non-financial corporate sectors reported in OECD Financial Statistics [17]. values of r for the countries in our sample are presented in Table 2.'"a····---il··--i------·----^------U . The real rate. There will be a windfall gain either to the net debtor firm or to its creditors. and the yield series we used represents after-tax yields. We estimated interest rate (r). For R. profits adjusted for depreciation and inventories. But this windfall gain is by nature transitory and therefore is not part of noise-free profits. In p as the difference between a measure between nominal liabilities and nominal of the nominal rate (R) on to long-term bonds 1 match the debt and an estimate of the real to the interest order adjustment charges the reflected in earnings.9 Debt Adjustment (DBT): The third source of bias in reported earnings is This bias can be corrected by adding pD to the interest overstatement. mean end-of-quarter R for the current and previous four quarters was used. adjustment to earnings consists of the percentage change in the wholesale price index multiplied by inventory holdings. where p is the long-run expected rate of inflation built into nominal interest rates 10 and D the and net debt per share of the index for which earnings are being measured. In any particular period realized inflation will differ from this rate. net debt refers to the difference assets. 10 12 The value of R for Italy is not so low as it would seem.

we adjusted partially adjusted earnings by adding to it our estimated pD.31 7. between cash earnings and the already earnings.·. U.-..1-III · I--II I1 .40 Average Inflation (p) Average Real Rate (r) D was estimated from annual balance sheets and income statements for the nonfinancial corporate sectors of the sample countries as published in OECD Financial Statistics.- - ·-·.- .71 1.1970:1 - 1979:4 L_ Average Nominal Rate (R) Canada France Germ an Italy Japan Netherlands U.47 12. --- 1- -...07 1.31 8..37 2.97 13.K. Table II Interest Rates and Inflation .I . the Netherlands.·-.06 7. These data were not available for Canada and First net nominal liabilities for each remaining country through 1979 were calculated from balance sheet share from 1969 To obtain a leverage measure that could be related to our price index. net nominal liabilities were then divided by depreciation as indicated by the corresponding year's income statement.· -.09 -0.11 3.10.--- .·----.38 13.34 8.27 -2. .24 10.-... .- -1 - -. .-I 1 -· · .. 9.28 -0. for each year data.l. - -.-.-.00 9. ------------ . measured gave us our as the difference D.39 8.·--. .72 8.~-..65% 10.61% 9. - . - . value of Finally.·· -I-III.---- .05% 1.19 4.S. Multiplying the resulting ratio of net debt to depreciation by depreciation per share of our price index.97 7.

Which Earnings Do Investors Capitalize? If we knew precisely which rules were used for computing profits in each country and were sure that investors were rational in making the appropriate adjustments. D. and the U. thus. Two alternative earnings smoothing procedures were considered. there would be no ambiguity regarding appropriate earnings adjustments.11. Germany. it would be misleading to assert that a particular earnings definition is the appropriate one for inclusion in our regression model. Correlations between stock prices and alternative measures of earnings vary considerably. That measure resulting in the highest correlation and. thus. two and three year averages adjusted for changes in the CPI. Of the eight countries considered earlier. we examined the correlations between various sets of partially (depreciation and inventory adjustments only) and fully (including debt adjustments) adjusted earnings and share prices. the about the measure of earnings that investors capitalize substantial interaction among the various adjustments apparent magnitude and even the observed direction of certain adjustments depend on which others are considered simultaneously. the lowest variability of PE ratios should be the best estimate of true earnings. in most countries some variety in accounting practices is allowed amb ig uo us. hence the rules themselves are adjustments to earnings for use in our regressions. However. we estimate two models for each of the have complete data: one using reported which we --- --------- . great care must be taken in drawing inferences since there is and. complete data for earnings adjustments were available only for five: France.S. and quarterly average as well as end-of-quarter stock prices were used.K. In order to decide on and used. However. the U. Japan.. five countries for Therefore. in the measures of earnings Given the differences across countries most closely associated with stock prices.

ER . 13 We were unable to estimate equations for partially adjusted earnings since our measure of them results in negative earnings in sane periods for most countries. or less believably as one in which market participants make the full required inflation adjustments to earnings with respect to A depreciation and interest but no adjustment for inventory valuation. earnings and one using fully adjusted earnings (partially adjusted earnings plus the debt adjustment). a large proportion To the extent that LIFO is used.14 Of all our assumptions regarding accounting principles used in canputing earnings in various countries.S. of finns use LIFO. The case in which y = 0 can be thought of either as a situation in which all firms in the market use LIFO. Even in the U.13 We also estimate our model with the ratio of price to dividend (the inverse of dividend yield) as the dependent variable on the presumption that dividends can be viewed as a faction of noise-free profits . in which case no inventory adjustment is required.CC + DBT INV variable hus becomes In [P/(E . we developed a specifi- cation which allowed reported earnings to be adjusted by a fraction of the inventory valuation adjustment (INV). (12) where EA represents fully adjusted earnings. Instead of writing EA = ER . the assumption that FIFO is used throughout is the most questionable.INV . The dependent E . the computed inventory valuation adjustment will produce a downward biased measure of partially or fully adjusted earnings. .CC + DBT)] as an 15 additional independent variable. ln [P/(E R .CC + DBT)] while ln (1 NV CC + DBT becanes an additional independent variable.CC + DBT)] and included We changed the dependent variable t6 n [1 INV/(E R .CC + DBT. INV In (1 CC+ DBT ) to both sides of our test equation. In an attempt to overcome this difficulty. value for y of unity would be consistent with all firms employing FIFO Taking logarithms of both sides of equation (13).III 12. we chose the more general ex pression (13 INV E ECC + DBT) (1 A (ER . in 14 If dividends are a constant fraction of noise-free earnings. where ER represents reported earnings.CC + DBT) ' where y can be presumed to take on sane value from the interval (0..1). we can add accounting.CC + DBT) (1 . 15 What we wanted was a specification which allowed us to estimate the fraction of our measure of INV which the stock market used in adjusting reported earnings for the effects of inflation. then a equation (8) will incorporate the logarithm of this fraction.

we employed generalized least squares in estimating equation (8). effect in statistically is the However. but the coefficients of these variables were generally insignificant.13. relevant results contradict the simple correlations reported ratio of price this to dividends is is Table I. Regression Results. 1 7 17 although the coefficients are significant only 16 Our preliminary regressions used end-of-quarter price in constructing the In an attempt to reduce noise in our price series. for the United States. since dividends presumably reflect the dividend/earnings to this regression. in term The is not included fail to noise-free since it Also.1 6 The results of using the logarithm of the ratio of Price/Dividend Model: average price to dividend as the dependent variable are reported in Table 3. The values which appear in 17 parentheses are t-statistics. dependent variable. United of the negatively related significant signs of the although Kingdom. martingale implies first-order serial correlation of the residuals. to only In all cases. The coefficients were estimated by a second-degree Almon polynomial. a 5 terms in equation (8) were treated as distributed lags over the current and previous seven quarters. Ij _ __ . The values for these terms presented below in Tables III and IV represent the suns of current and lagged Because the hypothesis that the change in stock price is a coefficients. While this measure of price resulted in a somewhat better fit. the a2 and those we obtained using end-of-quarter prices. we employed a measure of average price for the quarter in our final runs. no case coefficients inflation variable positive. the interest for the rates. the results presented in this section are not qualitatively different from In all cases. The cyclical term is earnings. is not not included. E. Regressions including growth and risk premiums were run. These results are not reported owing to space limitations.

.03 (.01 (1. 18 The two earnings measures employed are reported earnings and fully None of the measures could be computed for Italy adjusted earnings.64) -.02 (1.75 (18.89) 3.84 (13.01 (.09) -.26) . Price-Earnings Regressions: The results of regressions using the ratio of price to two alternative measures of earnings are reported in Table IV.85) -. like that from The Table III.46) .02) -0.05) 3.37 3.088 1.81) 1.00 (. is of not the strongly supportive rational valuation.80) 3.49 (11.52 (13.06 (5.51 -a/8-quarter.33) -. coefficients inflation variable generally fail to "undo" the coefficients of the nominal interest rate term.18 The general picture which of emerges.10) -. Table III Price to Dividend Regressions -.14.58) -.00 (.83) -.36 United States .00 04 France Germany Italy Japan Netherlands United Kingdom .30) -.03) 3.05 (2.01 (.00065 (.12) (2. 2.01 (. since earnings data corresponding to our index are not available and only reported-earnings regressions were run for Canada and the Netherlands since no depreciation figures were available for those countries.64 .01) 3.27) -.05 (12.1970:1 .33) -.01) -.87 .04 (1.59 (11.04 (1.88 (. second-degree distributed lag.64 (24.77) 3.1979: 4 Log Price/ Dividend0 Canada ao R INF a Rho Standard Error DurbinWatson 1.09) -.94 67 1.50) 3.04 (1. (1.

reported earnings Because current cost 9Again. have an insignificant impact on valuation. growth. we present results only for since needed depreciation data were not available. the coefficients for the nominal interest rate and inflation are negative although insignificant with both earnings measures. the countries We found near-zero coefficients for the INV term for all of in our sample except the United Kingdom and the United States. In order to avoid having to take logarithms of a negative inventory adjustment term. near zero For France. the coefficient for nominal interest rates is negative and nearly significant while the coefficient for inflation is significantly negative. the fall regression model was run for each country but the coefficients of business cycle. suggesting French firms use LIFO accounting or that investors overlook the necessary adjustments.15. the coefficient of the interest rate term is and insignificant in both regressions.05 level) negative signs for nominal interest rates and significant negative signs for inflation. This procedure changes the magnitude of the estimated coefficient of INV but not its sign. In the case of Japan. . it was necessary to multiply the estimated adjustment by a fraction (._ r· ______1_1____^____/__ . For the Netherlands. but the coefficient of The INV term appears to either that most inflation is significantly negative in both cases. both formulations show insignificant (at the . The equations for fully adjusted earnings include the inventory valuation adjustment term. is DIV/E were generally insignificant and only abbreviated results are presented here owing to space limitations.19 For Canada. In the case of Germany. with respect to both reported and fully adjusted earnings. risk premium.25). on the right hand side. whereas the equations for reported earnings do not include this variable.

accounting is commonly employed in the Netherlands. can be traced to tax effects.K. IV. reported earnings can be thought of as measures of partially adjusted earnings. there are no negative the U. For United Kingdam.S. the results findings of Modigliani and for the U. the results presented in this paper for the decade of and the coefficient of inflation is negative and the 1970's are consistent with the initial indications that stock prices are negatively related to nominal interest rates and inflation in a number of countries. inflation and stock prices is the result of systematic errors in valuation on the part of 20 This finding is of particular interest in light of Feldstein's [8] argument that much of the negative effect of inflation on stock prices in In the U. sane other effect must be operating. it is difficult to trace these results to a specific view of investor behavior. interest ratio the price-earnings not offset by the coefficient there is and of the inflation term. rates which have is a significantly negative impact on the Again. The results do serve to challenge instruments whose values are the traditional view that equities are real unaffected by inflation. However. and fully adjusted earnings. SUMMARY Taken together. the coefficient of the nominal interest rate variable is negative although insignificant significant.S. [18 . 2 0 Finally.III 16. corporate level since capital expenditures can be tax effects at the written off in one year as can changes in inventory holdings (Revzin Therefore. given the difficulty of specifying precisely which adjustments to reported earnings should be made and which adjustments are taken into account by investors. are consistent For both reported with the earlier Cohn. earnings a significant negative relationship between priceinterest rates accompanied by a negative but ratios insignificant relationship with inflation. The interesting question for further exploration is whether the observed relationship between interest rates. .

89 .25) 1.82) .22 (.90 .18 (10.1979:4 Pri Lo ce/) ( Pie! dLog Dividend Canada Reorted Earnings France Reported Earnings Fully Adjusted Earnings Germany Reported Earnings Fully Adjusted Earnings Japan Reported Earnings Fully Adjusted Earnings Netherlands Reported Earnings a R R INF~a/ IWL INV Standard oa RhoatsonError DurbinWatson 3.04 (.47) 2.94 .21) (3. 07 (4.06 2.1971:1 .82) 3.06) (2.32) -.30 United Kingdom Reported 3.94) .00 (. 08 (3. 00 (.60 (6.61) -.05 (1.076 1.32 3.27) -.97) -.31) -.85 (.50) 1.48 . Table IV Price to Earnings Regressions -.36) -.01 (10.129 .95) -.93 .18) .68 (10.10) 3.29) 3.92 .17. 10 (4.05) (1. 04 (4.15 .19) 2.072 1.94 .76) . second-degree distributed lag.95) .34) -.46) .51 (5.117 1.19) .01) .31) 1.102 1.75 .01 (.34) -.12 (.82 .118 2.00 1.12 .17) -.01 (.04 - 1.01 -.36) -.073 1.081 .41) -.29) .78 .38) -.090 1. 00 (. 07 (3. 09 (2.71 2.09 Earnings (8. 01 (.062 1. 10 (.092 1.00 .25 (2.85 (1.01 -.33 (12. 00 .01 (11. 06 (4.86) .85) -.01 (.88) Fully Adjusted Earnings United States Reported Earnings Fully Adjusted Earnings a/ -.23 (. 03 -. 03 (1.63 (9.20) -. _ --.60 .70 - 8-quarter.11 2.00 (. I --- . 01 (.69 3.70) .29) -.10) -.097 2.09 (6.10 (2.88 .14) (.

Under rational valuation. At the very least. these the risk premium changes in expected Our findings reflect an admittedly crude attempt to control factors. rising (falling) inflation tended to coincide with a fall (rise) in stock prices beyond that accounted for by a decline (an increase) in after-tax profits. the results suggest that during the decade. it is tempting to in valuation are made when there is errors significant inflation. While inflation may be proxying for some set of variables conclude which is producing that systematic the effects we observe. investors or linkages between structural causes of inflation and factors that reduce long-term earnings potential for firms. .18. the major factors in addition to changes in the risk-free rate that affect in the capitalization and rate applied to long-run true for real earnings are changes growth.

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