Inflation Illusion and Stock Prices

20 Pages Posted: 19 Jul 2010 Last revised: 28 Dec 2011

See all articles by John Y. Campbell

John Y. Campbell

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Tuomo Vuolteenaho

Arrowstreet Capital, LP; National Bureau of Economic Research (NBER)

Date Written: February 2004

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.

Suggested Citation

Campbell, John Y. and Vuolteenaho, Tuomo, Inflation Illusion and Stock Prices (February 2004). NBER Working Paper No. w10263, Available at SSRN: https://ssrn.com/abstract=1645104

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Tuomo Vuolteenaho

Arrowstreet Capital, LP ( email )

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National Bureau of Economic Research (NBER)

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