Inflation and stock returns

Stock returns, whether nominal or real, are commonly found to depend negatively on actual inflation, expected inflation and unexpected inflation. This runs contrary to the Fisher hypothesis generalised to apply to stocks, whereby stocks should be a hedge against inflation. However, another branch of finance, valuation theory, considers that the firm's equity is equal to the present value of future cash flows discounted at an appropriate market yield. Accordingly, if inflation is higher, the cash flows and the market yield are both adjusted upward, leaving the present worth unchanged. This present worth is the same if real (inflation-adjusted) cash flows are discounted at the real (inflation-adjusted) interest rate. Therefore valuation theory predicts that inflation is neutral on equity prices. This paper argues and presents evidence that this is indeed the case. When a fundamental variable, which is determined by a simple stock model, is included in the regressions, the effect of inflation on stock returns dissipates. Thus the observed negative relation between inflation and stock returns is due to a misspecification of the model. In reality, when the relation is properly formulated, inflation and stock returns are independent of each other.