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Inflation and the Valuation of Corporate Equities

  • Lawrence H. Summers

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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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
Date of revision:
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
Note: PE
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  1. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  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. 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.
  4. 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.
  5. Martin Feldstein, 1979. "Inflation, Tax Rules, and the Stock Market," NBER Working Papers 0403, National Bureau of Economic Research, Inc.
  6. Jeremy I. Bulow, 1979. "Analysis of Pension Funding Under Erisa," NBER Working Papers 0402, National Bureau of Economic Research, Inc.
  7. 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.
  8. 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.
  9. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
  10. 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.
  11. 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.
  12. Martin Feldstein & Lawrence Summers, 1983. "Inflation, Tax Rules, and the Long-term Interest Rate," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 153-185 National Bureau of Economic Research, Inc.
  13. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  14. Aaron, Henry J, 1976. "Inflation and the Income Tax," American Economic Review, American Economic Association, vol. 66(2), pages 193-99, May.
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