Inflation Illusion and Stock Prices

Tuomo Vuolteenaho and John Campbell

Scholarly Articles from Harvard University Department of Economics

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.

Date: 2004
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Published in American Economic Review

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Journal Article: Inflation Illusion and Stock Prices (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:hrv:faseco:3196090

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