Inflation Illusion and Stock Prices

By John Y. Campbell, Tuomo Vuolteenaho. The American Economic Review, 2004

497 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/21ca665f038dbb6cc906582d82487713f9fcba7a

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Citations in the corpus

A Comprehensive Look at the Empirical Performance ofEquity Premium Prediction II (2008, unknown): “The inflation rate: Campbell and Vuolteenaho (2004), Fama (1981), Fama and Schwert (1977), and Lintner (1975).”
Inflation Risk and the Inflation Risk Premium (2010, unknown): “Suffice it to say that many recent articles rely on money illusion to explain this empirical relationship (see, e.g. Campbell and Vuolteenaho, 2004).”
Predicting market returns using aggregate implied cost of capital (2013, unknown): “…Campbell (1987) and Fama and French (1989); net equity issuance (Baker and Wurgler (2000)); inflation: Nelson (1976), Fama and Schwert (1977) and Campbell and Vuolteenaho (2004); stock market variance: French, Schwert, and Stambaugh (1987) and Guo (2006); long-term government bond yield:…”
Asset Pricing: A Tale of Two Days (2014, unknown): “…market and bond risk premia observed across types of day, the Case I model of Bansal and Yaron (2004) (on which the SW model is based), the model of Campbell and Vuolteenaho (2004), as implemented empirically in that paper, the model of Brennan, Wang, and Xia (2004), and the Fama-French (1992)…”
Inflation and the Stock Market: Understanding the 'Fed Model' (2009, background): “For policy makers, if money illusion causes undue variation in equity prices during periods of ination uncertainty, this suggests another motive for ination stabilization policies, as Campbell and Vuolteenaho (2004) point out.”
Stock Returns, Aggregate Earnings Surprises, and Behavioral Finance (2006, background): “…interest rates is clear, but Modigliani and Cohn (1979) argue that prices even respond negatively to purely nominal changes in interest rates because investors mistakenly discount real earnings at nominal rates [see Nissim and Penman (2003) and Campbell and Vuolteenaho (2004) for recent evidence].”