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Inflation Illusion and Stock Prices

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  • John Y. Campbell
  • Tuomo Vuolteenaho

Abstract

We empirically decompose the S&P 500's dividend yield into (1) a rational forecast of long-run real dividend growth, (2) the subjectively expected risk premium, and (3) residual mispricing attributed to the market's forecast of dividend growth deviating from the rational forecast. Modigliani and Cohn's (1979) hypothesis and the persistent use of the Fed model' by Wall Street suggest that the stock market incorrectly extrapolates past nominal growth rates without taking into account the impact of time-varying inflation. Consistent with the Modigliani-Cohn hypothesis, we find that the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10263.

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Date of creation: Feb 2004
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Publication status: published as Campbell, John Y. and Tuomo Vuolteenaho. "Inflation Illusion And Stock Prices," American Economic Review, 2004, v94(2,May), 19-23.
Handle: RePEc:nbr:nberwo:10263

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  1. Ammer, John & Campbell, John, 1993. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Scholarly Articles 3382857, Harvard University Department of Economics.
  2. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  3. 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.
  4. Christopher Polk & Samuel Thompson & Tuomo Vuolteenaho, 2004. "New Forecasts of the Equity Premium," NBER Working Papers 10406, National Bureau of Economic Research, Inc.
  5. Vuolteenaho, Tuomo & Campbell, John, 2004. "Inflation Illusion and Stock Prices," Scholarly Articles 3196090, Harvard University Department of Economics.
  6. Mishkin, F.S., 1988. "What Does The Term Structure Tell Us About Future Inflation?," Papers fb-_88-29, Columbia - Graduate School of Business.
  7. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-79, March.
  8. Boudoukh, Jacob & Richardson, Matthew, 1993. "Stock Returns and Inflation: A Long-Horizon Perspective," American Economic Review, American Economic Association, vol. 83(5), pages 1346-55, December.
  9. Brandt, Michael W. & Wang, Kevin Q., 2003. "Time-varying risk aversion and unexpected inflation," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1457-1498, October.
  10. Frederic S. Mishkin, 1991. "The Information in the Longer Maturity Term Structure about Future Inflation," NBER Working Papers 3126, National Bureau of Economic Research, Inc.
  11. Geske, Robert & Roll, Richard, 1983. " The Fiscal and Monetary Linkage between Stock Returns and Inflation," Journal of Finance, American Finance Association, vol. 38(1), pages 1-33, March.
  12. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
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