Inflation and stock prices.

I've been checking out a new blog on Reuters by a Rolfe Winkler. It's pretty good, although his recent posting on inflation and stock prices makes the common mistake of confusing nominal and real growth rates. In economics parlance, we call this inflation or money illusion.

The basic error of inflation illusion is that a nominal discount rate is used to present value a firm's cash flows while a real growth rate is used to grow them. The result is that when inflation increases, the discount rate goes up and the present value of cash flows declines. This leads to the oft-cited conclusion that stock prices will decline when inflation increases.

In fact, stocks are natural hedges against inflation because the cash flows are real. This means that they increase with inflation. As prices go up, the firm's revenue and cash flows increase accordingly.

At the simplest level, consider the Dividend Discount Model.

P = D1/r-g

D1 is the dividend expected next year. r is the nominal discount rate and g is the growth rate. An increase in inflation will increase r through the risk free rate. g will also increase at the rate of inflation. Because the numerator is r-g, the effect of inflation will cancel out.

Mr Winkler is not alone in suffering from inflation illusion. The effect has been well documented. The original idea of inflation illusion affecting stock prices was proposed by Franco Modigliani and Richard Cohn in 1979. Since then, numerous academics have studied the issue and found evidence of inflation illusion. For example, John Campbell and Tuomo Vuolteenaho find evidence in their American Economic Review paper in 2004. Yours truly also found evidence for inflation illusion in my 2002 Journal of Financial and Quantitative Analysis with Jay Ritter.

Inflation illusion also affects house prices, but that's a topic for another day...