July 04, 2005
Modigliani-Cohn's Hypothesis that the Stock Market Is Confused Receives More Support
Expertly done. Campbell and Vuolteenaho take sides with Modigliani and Cohn: the U.S. stock market simply doesn't--or didn't--understand the difference between nominal and real interest rates. Since nominal rates are real rates plus inflation, this means the stock market is low when inflation is high, and high when inflation is low.
Their model does, however, does not work for the 1990s: the close association between their estimates of mispricing and inflation breaks down in the past decade and a half.
John Y. Campbell and Tuomo Vuolteenaho (2004), "Inflation Illusion and Stock Prices" (Cambridge: NBER Working Paper 10263) http://www.nber.org/papers/w10263.
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.
Other related references:
- Cliﬀord Asness (2000), "Stocks versus Bonds: Explaining the Equity Risk Premium," Financial Analysts Journal March/April, 96-113.
- Cliﬀord Asness (2003), "Fight the Fed Model: The Relationship between Future Returns and Stock and Bond Market Yields, Journal of Portfolio Management Fall, 11-24.
- John Y. Campbell and John Ammer (1993), "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance 48, 3—37.
- John Y. Campbell and Robert J. Shiller (1988), The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies 1, 195—228.
- Franco Modigliani and Richard Cohn (1979), "Inflation, Rational Valuation, and the Market," Financial Analysts’ Journal.
- Christopher Polk, Samuel Thompson, and Tuomo Vuolteenaho (2003), "New Forecasts of the Equity Premium" (Evanston, IL: Northwestern University).
- John Burr Williams (1938), "Evaluation by the Rule of Present Worth," in The Theory of Investment Value, 55-75.
Posted by DeLong at July 4, 2005 04:57 PM