Monday, July 7, 2008

Inflation and stock prices

Stocks should be a good hedge against inflation - they are claims on real cash flows. Bonds on the other hand should do terribly when inflation increases - they are claims on nominal cash flows that cannot adjust. In reality though, stocks do pretty poorly when inflation increases. This article in the Economist offers an explanation - that earnings decline during periods of inflation.

An alternative explanation, and a better one I think, is that investors don't understand how to value stocks in the presence of inflation. They discount real cash flows using nominal rates and they fail to realize that the reduction in earnings due to higher interest costs is merely illusory. In essence, investors suffer from money or inflation illusion. My 2002 Journal of Financial and Quantitative Analysis paper with Jay Ritter discusses this, and several others (here here and here) provide further evidence.