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Inflation and the Valuation of Corporate Equities

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  • Lawrence H. Summers

Abstract

This paper examines the relationship between inflation and the return on individual corporate securities. This question is of substantial importance in light of the puzzling behavior of the stock market over the last decade. Conventional financial theory holds that equity should be a good inflation hedge since it represents a claim of real rather than nominal assets. Yet a negative relationship between both expected and unexpected inflation and stock market returns has been widely documented. This relationship, which appears to antedate the surge in inflation over the last 15 years. might provide an explanation for the market's surprising recent performance. This paper studies differences across firms in the response of stock market values to changes in expected inflation in an effort to explore the reasons for the aggregate negative relationship between inflation and stock market values. Two opposing hypotheses about the impact of inflation on market valuation are contrasted. The "inflation illusion" hypothesis holds that investors are not able to see through nominal accounting statements and respond to reported rather than real profits. The opposing "tax effects" hypothesis holds that firms which report spuriously high profits due to inflation are penalized because the extra tax burden incurred reduces real profits. The results from the 1970's strongly bear out the predictions of the tax effects hypothesis. Aggregate calculations suggest that the interaction of inflation and taxation can account for a large part of the decline in the stock market which has been observed over the past decade. A significant part of the remainder appears to be due to increasing investor awareness of the need to adjust for historic cost depreciation.

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  • Lawrence H. Summers, 1981. "Inflation and the Valuation of Corporate Equities," NBER Working Papers 0824, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0824
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    References listed on IDEAS

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    Cited by:

    1. Pearce, Douglas K & Roley, V Vance, 1985. "Stock Prices and Economic News," The Journal of Business, University of Chicago Press, vol. 58(1), pages 49-67, January.
    2. Pindyck, Robert S, 1984. "Risk, Inflation, and the Stock Market," American Economic Review, American Economic Association, vol. 74(3), pages 335-351, June.
    3. Vadim Ye. Zyamalov, 2017. "Comparison of the Predictive Ability of Single and Multi-Regime Models of Stock Market Dynamics," Finansovyj žhurnal — Financial Journal, Financial Research Institute, Moscow 125375, Russia, issue 2, pages 64-75, April.
    4. Bampinas, Georgios & Panagiotidis, Theodore, 2016. "Hedging inflation with individual US stocks: A long-run portfolio analysis," The North American Journal of Economics and Finance, Elsevier, vol. 37(C), pages 374-392.
    5. Steven A. Sharpe, 1999. "Stock prices, expected returns, and inflation," Finance and Economics Discussion Series 1999-02, Board of Governors of the Federal Reserve System (U.S.).
    6. Konchitchki, Yaniv, 2011. "Inflation and Nominal Financial Reporting: Implications for Performance and Stock Prices," MPRA Paper 52928, University Library of Munich, Germany.
    7. Lawrence H. Summers, 1983. "Observations on the Indexation of Old Age Pensions," NBER Chapters, in: Financial Aspects of the United States Pension System, pages 231-258, National Bureau of Economic Research, Inc.
    8. Md. Mohiuddin & Md. Didarul Alam & Abdullah Ibneyy Shahid, 2008. "An Empirical Study of the Relationship between Macroeconomic Variables and Stock Price: A Study on Dhaka Stock Exchange (DSE)," AIUB Bus Econ Working Paper Series AIUB-BUS-ECON-2008-21, American International University-Bangladesh (AIUB), Office of Research and Publications (ORP), revised Jun 2008.
    9. Lawrence H. Summers, 1982. "The Nonadjustment of Nominal Interest Rates: A Study of the Fisher Effect," NBER Working Papers 0836, National Bureau of Economic Research, Inc.
    10. Modigliani, Franco. & Cohn, Richard A., 1984. "Inflation and corporate financial management," Working papers 1572-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    11. Markus K. Brunnermeier & Sergio A. Correia & Stephan Luck & Emil Verner & Tom Zimmermann, 2023. "The Debt-Inflation Channel of the German Hyperinflation," NBER Working Papers 31298, National Bureau of Economic Research, Inc.
    12. Lawrence H. Summers, 1985. "The Asset Price Approach to the Analysis of Capital Income Taxation," Palgrave Macmillan Books, in: George R. Feiwel (ed.), Issues in Contemporary Macroeconomics and Distribution, chapter 19, pages 429-443, Palgrave Macmillan.
    13. Turuntseva, M. & Zyamalov, V., 2016. "Stock Markets under the Changing Terms of Trade," Journal of the New Economic Association, New Economic Association, vol. 31(3), pages 93-109.
    14. Lawrence H. Summers, 1982. "Tax Policy, the Rate of Return, and Savings," NBER Working Papers 0995, National Bureau of Economic Research, Inc.

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