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Inflation and the Valuation of Corporate Equities

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  • Lawrence H. Summers

Abstract

This paper examines the relationship between inflation and the return on individual corporate securities. This question is of substantial importance in light of the puzzling behavior of the stock market over the last decade. Conventional financial theory holds that equity should be a good inflation hedge since it represents a claim of real rather than nominal assets. Yet a negative relationship between both expected and unexpected inflation and stock market returns has been widely documented. This relationship, which appears to antedate the surge in inflation over the last 15 years. might provide an explanation for the market's surprising recent performance. This paper studies differences across firms in the response of stock market values to changes in expected inflation in an effort to explore the reasons for the aggregate negative relationship between inflation and stock market values. Two opposing hypotheses about the impact of inflation on market valuation are contrasted. The "inflation illusion" hypothesis holds that investors are not able to see through nominal accounting statements and respond to reported rather than real profits. The opposing "tax effects" hypothesis holds that firms which report spuriously high profits due to inflation are penalized because the extra tax burden incurred reduces real profits. The results from the 1970's strongly bear out the predictions of the tax effects hypothesis. Aggregate calculations suggest that the interaction of inflation and taxation can account for a large part of the decline in the stock market which has been observed over the past decade. A significant part of the remainder appears to be due to increasing investor awareness of the need to adjust for historic cost depreciation.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0824.

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Date of creation: Dec 1981
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Publication status: published as (With M.Feldstein) Published as "Inflation and the Taxation of Capital Income in the Corporate Sector", NTJ, Vol. 32, no. 4 (1979): 445-470.
Handle: RePEc:nbr:nberwo:0824

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  1. Martin Feldstein & Lawrence Summers, 1978. "Inflation, Tax Rules, and the Long Term-Interest Rate," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 9(1), pages 61-110.
  2. Bodie, Zvi, 1976. "Common Stocks as a Hedge against Inflation," Journal of Finance, American Finance Association, vol. 31(2), pages 459-70, May.
  3. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  4. William C. Brainard & John B. Shoven & Laurence Weiss, 1980. "The Financial Valuation of the Return to Capital," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(2), pages 453-512.
  5. Hong, Hai, 1977. "Inflation and the Market Value of the Firm: Theory and Tests," Journal of Finance, American Finance Association, vol. 32(4), pages 1031-48, September.
  6. Feldstein, Martin, 1980. "Inflation, tax rules and the stock market," Journal of Monetary Economics, Elsevier, vol. 6(3), pages 309-331, July.
  7. Aaron, Henry J, 1976. "Inflation and the Income Tax," American Economic Review, American Economic Association, vol. 66(2), pages 193-99, May.
  8. Jeremy I. Bulow, 1979. "Analysis of Pension Funding Under Erisa," NBER Working Papers 0402, National Bureau of Economic Research, Inc.
  9. John B. Shoven & Jeremy I. Bulow, 1975. "Inflation Accounting and Nonfinancial Corporate Profits: Physical Assets," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(3), pages 557-612.
  10. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
  11. Jaffe, Jeffrey F & Mandelker, Gershon, 1976. "The "Fisher Effect" for Risky Assets: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 31(2), pages 447-58, May.
  12. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
  13. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  14. Pesando, James E, 1975. "A Note on the Rationality of the Livingston Price Expectations," Journal of Political Economy, University of Chicago Press, vol. 83(4), pages 849-58, August.
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Cited by:
  1. Modigliani, Franco. & Cohn, Richard A., 1984. "Inflation and corporate financial management," Working papers 1572-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Lawrence H. Summers, 1984. "The Asset Price Approach to the Analysis of Capital Income Taxation," NBER Working Papers 1356, National Bureau of Economic Research, Inc.
  3. Konchitchki, Yaniv, 2011. "Inflation and Nominal Financial Reporting: Implications for Performance and Stock Prices," MPRA Paper 52928, University Library of Munich, Germany.
  4. Lawrence H. Summers, 1982. "Tax Policy, the Rate of Return, and Savings," NBER Working Papers 0995, National Bureau of Economic Research, Inc.
  5. Md. Mohiuddin & Md. Didarul Alam & Abdullah Ibneyy Shahid, 2008. "An Empirical Study of the Relationship between Macroeconomic Variables and Stock Price: A Study on Dhaka Stock Exchange (DSE)," AIUB Bus Econ Working Paper Series AIUB-BUS-ECON-2008-21, American International University-Bangladesh, Office of Research and Publications (ORP), revised Jun 2008.
  6. Steven A. Sharpe, 1999. "Stock prices, expected returns, and inflation," Finance and Economics Discussion Series 1999-02, Board of Governors of the Federal Reserve System (U.S.).

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