Accounting and the Macroeconomy: The Case of Aggregate Price-Level Effects on Individual Stocks

The author used financial statement analysis to examine systematic stock-valuation effects of aggregate price-level changes on individual companies, focusing on the implications for researchers and investment practitioners. Among other insights, he showed that (1) inflation-based investment strategies conditioned on available information resulted in significant risk-adjusted returns and (2) investing using the inflation effect on companies’ net monetary holdings resulted in insignificant abnormal hedge returns whereas investing using the inflation effect on companies’ nonmonetary holdings consistently yielded economically and statistically significant abnormal hedge returns. Taken together, the study sheds new light on the cross-sectional effects of inflation, with substantial implications for valuation.This study sheds new light on the cross-sectional effects of inflation, which have substantial implications for stock valuation. I used financial statement analysis to examine systematic stock-valuation effects of aggregate price-level changes on individual companies, focusing on the implications for both researchers and investment practitioners. I developed inflation-adjustment procedures that are straightforward for investors to implement in real time for extracting the inflation effect on individual companies. I found that inflation-based investment strategies conditioned on information available to investors as of the initial investment and rebalancing dates result in significant risk-adjusted returns. I also investigated the sources of abnormal returns to inflation-based investment strategies. Specifically, I estimated two separate components of the inflation effect on individual companies, one based on only monetary holdings (using the net position of monetary holdings) and the other based on only nonmonetary holdings. Investigating the stock-valuation implications of extracting the components-based inflation effect revealed striking evidence. In particular, investing based on the inflation effect on companies’ net monetary holdings results in insignificant abnormal hedge returns. In contrast, investing based on the inflation effect on companies’ nonmonetary holdings consistently yields economically and statistically significant abnormal hedge returns. These findings indicate that inflation-based abnormal hedge returns are driven not by the exposure of companies’ net monetary holdings to inflation but, rather, by the exposure of their nonmonetary holdings to inflation. These results are consistent with the fact that companies’ nonmonetary holdings are usually held for several years and thus accumulate inflationary effects over time whereas their monetary holdings are, on average, naturally hedged because the exposure of monetary assets cancels the exposure of monetary liabilities for the average company. In addition, I examined the direction of the stock returns to real-time investment strategies.