Effect Of Inlation On Nominal And Real Stock Returns A Behavioral View

The main goal of this study is to shed light on different aspects of the correlation between stock market returns and inflation Using historical monthly rates of inflation calculated by the Israel Central Bureau of Statistics and historical monthly returns on six leading stock indices of the Tel Aviv Stock Exchange we document that nominal stock index returns do not compensate investors either for contemporaneous inflation inflation rate registered during the same month as the index return or for previous month s inflation inflation rate officially announced during the month when the index return is observed In addition the results indicate that real stock index returns calculated by deducting the rate of inflation from the nominal return rate are negatively correlated with contemporaneous inflation rates We suggest a behavioral explanation for these findings based on the assumption that investors perceive inflation itself as bad news and subsequently downwardly update their estimates of at least real expected cash flows from holding the stocks and or upwardly update the expected risk levels of the stocks