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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.

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Posted by DeLong at July 4, 2005 04:57 PM