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Inflation-Induced Valuation Errors in the Stock Market

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Abstract

Modigliani and Cohn (1979) put forth a behavioral finance model that predicted mispricing of stocks in the presence of changing inflation. The co-movement of the stock market E/P ratio with the nominal bond yield observed since the mid-1960s (when U.S. inflation started rising) is consistent with the Modigliani-Cohn hypothesis. A regression model that includes a constant term and three nominal variables can account for 70 percent of the variance in the observed E/P ratio over the past four decades. However, the success of this model in describing investor behavior should not be confused with the model’s ability to forecast what investors should really care about, namely, long-run real returns.

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  • Lansing, Kevin, 2005. "Inflation-Induced Valuation Errors in the Stock Market," Journal of Financial Transformation, Capco Institute, vol. 13, pages 124-126.
    • Handle: RePEc:ris:jofitr:0828
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    Cited by:

    1. Jung, Kuk Mo & Pyun, Ju Hyun, 2023. "A long-run approach to money, unemployment, and equity prices," Economic Modelling, Elsevier, vol. 125(C).
    2. Alain Durré & Pierre Giot, 2007. "An International Analysis of Earnings, Stock Prices and Bond Yields," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(3‐4), pages 613-641, April.
    3. Zheng Liu & Mark M. Spiegel, 2011. "Boomer retirement: headwinds for U.S. equity markets?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue aug22.
    4. Ricardo Lagos & Shengxing Zhang, 2019. "A Monetary Model of Bilateral Over-the-Counter Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 205-227, July.
    5. Samuel Aubert & Pierre Giot, 2007. "An international test of the Fed model," Journal of Asset Management, Palgrave Macmillan, vol. 8(2), pages 86-100, July.
    6. Adel A. Al-Sharkas & Marwan Al-Zoubi, 2011. "Stock Prices and Inflation: Evidence from Jordan, Saudi Arabia, Kuwait, and Morocco," Working Papers 653, Economic Research Forum, revised 12 Jan 2011.
    7. Alain Durré & Pierre Giot, 2007. "An International Analysis of Earnings, Stock Prices and Bond Yields," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(3-4), pages 613-641.
    8. Maria Ludovica Drudi & Federico Calogero Nucera, 2022. "Economic fundamentals and stock market valuation: a CAPE-based approach," Temi di discussione (Economic working papers) 1393, Bank of Italy, Economic Research and International Relations Area.

    More about this item

    Keywords

    Inflation Illusion; Fed Model; Behavioral Finance;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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