July 12, 2005
The Stock Market Suffers from Money Illusion
Randy Cohen politely inquires why I haven't read his--excellent--Modigliani-Cohn paper in the QJE.
Ummm... Indolence? Forgetfulness?... It is embarrassing because it is directly on point to what I regard as one of my core competences, and because I now remember that Bob Hall was praising it at lunch at the Women's Faculty Club in... April?
You may be interested to know that Tuomo Vuolteenaho did not feel his paper with John Campbell on Modigliani and Cohn closed the case. The problem was that although their results are compelling, they admit of a plausible rational explanation: high-inflation periods are times of high risk, and so the equity premium is rationally high at those times. To test this possibility, Tuomo, Christopher Polk and I wrote the attached paper, which is in the May 2005 QJE. The paper takes advantage of the fact that if the equity premium is high for risk-related reasons, then there is a cross-sectional implication: high-beta stocks should greatly outperform low-beta stocks in these periods. On the other hand, if M-C are right the inflation-driven mispricing will apply to all stocks equally, causing all stocks to be equally underpriced. The tests clearly show the latter is the case. This provides powerful confirmation of M-C, since it relies on a prediction about the relative performance of high- and low-beta stocks which was almost certainly not considered by M-C when they formulated their hypothesis.
As a side benefit, the paper shows that the basic failure of the CAPM (the failure of high-beta stocks to have much higher returns than low-beta) is explained by the M-C hypothesis. Indeed this failure only occurs in the high-inflation periods of the past century; the rest of the time the beta-return relationship works as the CAPM predicts.
Here's the abstract:
Randolph B. Cohen, Christopher Polk, and Tuomo Vuolteenaho (2005), "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," Quarterly Journal of Economics (May): Modigliani and Cohn  hypothesize that the stock market suﬀers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors towards risk. Our empirical resuts support the hypothesis that the stock market suﬀers from money illusion.
There is, I think, one potential hole: the possibility that times of high inflation are times of high perceived political risk--of confiscatory corporate taxation, for example--but that this risk has a very different distribution across corporations than "normal" beta-systematic risk.
Posted by DeLong at July 12, 2005 02:43 PM