Inflation Illusion and Stock Prices

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Inflation Illusion and Stock Prices

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Title: Inflation Illusion and Stock Prices
Author: Vuolteenaho, Tuomo; Campbell, John

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Citation: Campbell, John Y., and Tuomo Vuolteenaho. 2004. Inflation illusion and stock prices. American Economic Review 94, no. 2: 19-23.
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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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