Stock Market Returns and Inflation: Illusion or Regimes?

Which better explains the relationship between the inflation rate and stock market returns: the inflation illusion hypothesis, or a two-regime hypothesis? The former proposes that the typical investor irrationally raises (lowers) the required rate of return from equities (discount rate) as the inflation rate rises (falls), thereby undervaluing (overvaluing) stocks. The latter proposes that aggregate demand (supply) shocks drive a positive (negative) relationship between the inflation rate and stock returns. In his January 2009 paper entitled “Stock Returns and Inflation Revisited”, Bong-Soo Lee re-examines these hypotheses using long run U.S. data. Using stock return and inflation rate data spanning 1927-2007, he concludes that:

• The relationship between inflation rate and stock returns in the U.S. is positive in the pre-war (World War II) period, negative in the post-war period, and a little negative for the entire sample period. In other words, a high inflation rate indicates stock undervaluation post-war but overvaluation pre-war. More specifically:
  • Pre-war, aggregate demand shocks drive a positive relationship between inflation rate and stock returns. Decreases in money supply depress both the inflation rate and stock prices.
  • Post-war, aggregate supply shocks drive a negative relationship between inflation rate and stock returns. Increases in oil price elevate the inflation rate but depress stock prices.
• The inflation illusion hypothesis can explain the post-war negative relationship between between inflation rate and stock returns, but not the pre-war positive relationship. A two-regime hypothesis can explain both.

The author concludes with the following questions:

“With the recent severe financial downturn and looming recession, we anticipate some deflationary pressure. Does this imply that we will have a booming stock market with overpriced equities as the…inflation illusion hypothesis suggests? Or do we anticipate a declining stock market with underpriced equities as the pre-war period experience and the two-regime hypothesis suggest?”

In summary, the current environment may challenge the lifetime experience of most investors regarding the relationship between the inflation rate and stock returns.

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