Inflation-Induced Valuation Errors in the Stock Market

Modigliani and Cohn (1979) put forth a behavioral finance model that predicted mispricing of stocks in the presence of changing inflation. The co-movement of the stock market E/P ratio with the nominal bond yield observed since the mid-1960s (when U.S. inflation started rising) is consistent with the Modigliani-Cohn hypothesis. A regression model that includes a constant term and three nominal variables can account for 70 percent of the variance in the observed E/P ratio over the past four decades. However, the success of this model in describing investor behavior should not be confused with the model’s ability to forecast what investors should really care about, namely, long-run real returns.