Understanding Two Remarkable Findings about Stock Yields and Growth

Abstract

Two regularities regarding stock prices and expected inflation have received less attention than they deserve. First, earnings and dividend yields move with long-term expected inflation and risk-free rates. Second, analysts’ forecasts of nominal growth, not real growth, vary little with expected inflation. These patterns are remarkable because financial economists predict exactly the opposite. One explanation for these contrary findings is that stock prices are too high (low) when inflation is low (high), because investors confuse nominal and real growth rates. The authors assert that investors are unlikely to be so systematically naive about expected inflation and argue that the contrary evidence is, in fact, consistent with a rational market. The key insight offered by the authors is that reported earnings include inflationary holding gains, which causes higher earnings yields when inflation is high (the first regularity) and, in turn, explains why forecasts of nominal growth need not vary with inflation (the second regularity).

TOPICS: Portfolio theory, statistical methods, in markets