Inflation Illusion and Post-Earnings-Announcement Drift

Abstract

This paper examines the cross-sectional implications of the inflation illusion hypothesis for the post-earnings-announcement drift. The inflation illusion hypothesis, which was proposed by Modigliani and Cohn (1979), suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rate, and this causes firms whose earnings growth is positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns and earnings announcement returns of SUE-sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the results of Bernard and Thomas (1989) on the ability of lagged SUE to predict future returns of SUE-sorted stocks.

Keywords: Inflation illusion, earnings momentum, post-earnings-announcement drift, market efficiency

JEL Classification: G14, M41, M43, E31