Inflation Illusion and Post-Earnings-Announcement Drift

Journal of Accounting Research, Forthcoming

Posted: 15 Apr 2005

See all articles by Tarun Chordia

Tarun Chordia

Emory University - Department of Finance

Lakshmanan Shivakumar

London Business School

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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

Suggested Citation

Chordia, Tarun and Shivakumar, Lakshmanan, Inflation Illusion and Post-Earnings-Announcement Drift. Journal of Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=690081

Tarun Chordia

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States
404-727-1620 (Phone)
404-727-5238 (Fax)

Lakshmanan Shivakumar (Contact Author)

London Business School ( email )

Regent's Park
London, NW1 4SA
United Kingdom
+44 20 7000 8115 (Phone)
+44 20 7000 8101 (Fax)

HOME PAGE: http://faculty.london.edu/lshivakumar/

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