Inflation-induced valuation errors in the stock market

A recent front-page article in the Wall Street Journal documented an increasing tendency among economists to move away from theories of efficient stock market valuation in favor of "behavioral" models that emphasize the role of irrational investors (see Hilsenrath 2004). The long-run rate of return on stocks is ultimately determined by the stream of corporate earnings distributions (cash flows) that accrue to shareholders. In assigning prices to stocks, efficient valuation theory says that rational investors should discount real cash flows using real interest rates or discount nominal cash flows using nominal interest rates. Twenty-five years ago, Modigliani and Cohn (1979) put forth the hypothesis that investors may irrationally discount real cash flows using nominal interest rates - a behavioral trait that would lead to inflation-induced valuation errors. This Economic Letter examines some recent research that finds support for the Modigliani-Cohn hypothesis. In particular, studies show that the Standard & Poor's (S&P) 500 stock index tends to be undervalued during periods of high expected inflation (such as the late 1970s and early 1980s) and overvalued during periods of low expected inflation (such as the late 1990s and early 2000s). This result implies that the long bull market that began in 1982 can be partially attributed to the stock market's shift from a state of undervaluation to one of overvaluation. Going forward, the return on stocks could be influenced by a shift in the opposite direction.