IRRELEVANCE OF INFLATION: THE 20 FAMA-FRENCH STOCKS

Abstract

Purpose - The relation between inflation and stock returns has been widely scrutinized. Its importance transcends finding just a simple relation, and has repercussions on the conduct of monetary policy. Theoretically, the relation should be positive and one-to-one. However, early on, the empirical relation was found to be statistically significantly negative. This paper contributes to the theoretical and empirical debate. The null hypothesis is that inflation is irrelevant to stock returns. Therefore, neither a positive theoretical, nor a negative empirical relation, should robustly hold. This position is in accordance to the basic principles of modern corporate finance, which state that the real and nominal equity values are equal. Methodology - The paper starts with simple correlations and presents the probability distributions and histograms of all variables. All distributions are characterized by significant outliers. A theoretical model that excludes inflation is introduced, and the statistical significance of including inflation is tested. The quest covers the 20 Fama-French stock portfolios, classified by their percentiles of equity values. Hence, both bilateral and multilateral regressions are carried out. Findings – Initially bilateral correlations were found to be negative consistent with the early empirical evidence. However, by using robust standard errors, robust least squares, and quantile regressions, the evidence is totally reversed. There is strong support for the irrelevance of inflation. This is true if the investor is sophisticated, i.e. she does not give too much attention to simple bilateral correlations, if she utilizes advanced economic procedures like robust least squares and quantile regressions, if she adjusts for residual autocorrelation and heteroscedasticity, and if she incorporates fundamental variables in the estimation process. Conclusion - Hence the prima facie evidence of non-neutrality is challenged by this paper’s analysis. In opposition to the conviction of many economists, and despite their inherent resistance, the paper argues for inflation irrelevance.

Keywords

• inflation irrelevance
• Fama-French stocks
• model of stock returns
• fallacious evidence
• robust least squares
• quantile regressions
• bilateral and multilateral relations

References

1. Al-Nassar, N. S., & Bhatti, R. H. (2019). Are common stocks a hedge against inflation in emerging markets? Journal of Economics and Finance, 1-35.
2. Anari, A., & Kolari, J. (2001). Stock prices and inflation. Journal of Financial Research, 24(4), 587-602. https://doi.org/10.1111/j.1475-6803.2001.tb00832.x
3. Azar, S. A. (2010). Inflation and stock returns. International Journal of Accounting and Finance, 2(3-4), 254-274. https://doi.org/10.1504/IJAF.2010.034399
4. Azar, S. A. (2013). The spurious relation between inflation uncertainty and stock returns: evidence from the US. Review of Economics & Finance, 3, 99-109.
5. Azar, S. A. (2014a). The determinants of US stock market returns. Open Economics and Management Journal, 1(1), 1-13. https://doi.org/10.2174/2352630001401010001
6. Azar, S. A. (2014b). Inflation and stock returns II. International Journal of Economics and Finance, 6(1), 208-216. https://doi.org/10.5539/ijef.v6n1p208
7. Azar, S. A. (2015). The equity premium and inflation: Evidence from the US. Applied Finance and Accounting, 1, 1, 30-36.
8. Azar, S. A. (2020a). Irrelevance of Inflation and Inflation Uncertainty to Stock Returns, Book Publisher International (India and UK).

9. Azar, S. A. (2020b). Hypothesis testing when the same variable appears on both sides of the regression, The Empirical Economics Letters, 19(3), 221-225.
10. Azar, S. A. (2020c). Irrelevance of inflation: The Dow stocks. Accounting and Finance Research. 9, 1, 45-66. https://doi.org/10.5430/afr.v9n1p45
11. Azar, S. A. (2020d). Irrelevance of Inflation: Six Stock Market Indices, Book Publisher International (India and UK).
12. Boamah, M. I. (2017). Common stocks and inflation: an empirical analysis of G7 and BRICS. Atlantic Economic Journal, 45(2), 213-224. https://doi.org/10.1007/s11293-017-9543-9
13. Bodie, Z. (1976). Common stocks as a hedge against inflation. The Journal of Finance, 31(2), 459-470. https://doi.org/10.1111/j.1540-6261.1976.tb01899.x
14. Boudoukh, J., & Richardson, M. (1993). Stock returns and inflation: A long-horizon perspective. The American economic review, 83(5), 1346-1355.
15. Brealey, R. A., Myers, S. C., & Allen, F. (2017) Principles of Corporate Finance, McGraw-Hill, 12th edition.
16. Campbell, J. Y., & Vuolteenaho, T. (2004). Inflation illusion and stock prices. American Economic Review, 94(2), 19-23. https://doi.org/10.1257/0002828041301533
17. Crosby, M. (2001). Stock returns and inflation. Australian Economic Papers, 40(2), 156-165.
18. Eldomiaty, T., Saeed, Y., Hammam, R., & AboulSoud, S. (2020). The associations between stock prices, inflation rates, interest rates are still persistent. Empirical evidence from stock duration model. Journal of Economics, Finance and Administrative Science, 25(49), 149-162.
19. Ely, D. P., & Robinson, K. J. (1997). Are stocks a hedge against inflation? International evidence using a long-run approach. Journal of International Money and Finance, 16(1), 141-167. https://doi.org/10.1016/S0261-5606(96)00039-3
20. Engle, R. F., & Granger, C. W. (1987). Co-integration and error correction: representation, estimation, and testing. Econometrica: Journal of the Econometric Society, 251-276. https://doi.org/10.2307/1913236
21. Fama, E. F. (1981). Stock returns, real activity, inflation, and money. The American Economic Review, 71(4), 545-565.
22. Fama, E. F., & French, K. R. (2002). The equity premium. The Journal of Finance, 57(2), 637-659. https://doi.org/10.1111/1540-6261.00437
23. Fama, E. F., & Schwert, G. W. (1977). Asset returns and inflation. Journal of Financial Economics, 5(2), 115-146. https://doi.org/10.1016/0304-405X(77)90014-9
24. Feldstein, M. (1980). Inflation, tax rules and the stock market. Journal of Monetary Economics, 6(3), 309-331. https://doi.org/10.1016/0304-3932(80)90045-8
25. Fisher, I. (1930). The Theory of Interest, as Determined by Impatience to Spend Income and Opportunity to Invest it. New York: Macmillan.
26. Geske, R., & Roll, R. (1983). The fiscal and monetary linkage between stock returns and inflation. The Journal of Finance, 38(1), 1-33. https://doi.org/10.1111/j.1540-6261.1983.tb03623.x
27. Gordon, M. J. (1959). Dividends, earnings and stock prices. Review of Economics and Statistics, 41, (2), 99-105.
28. Gordon, M. J. (1962). The investment, financing, and valuation of the corporation. Homewood, IL: RD Irwin.
29. Gordon, M. J., and Shapiro, E. (1956). Capital equipment analysis: The required rate of profit. Management Science, 3, (1), 102-110
30. Gultekin, N. B. (1983). Stock market returns and inflation: evidence from other countries. The Journal of Finance, 38(1), 49-65. https://doi.org/10.1111/j.1540-6261.1983.tb03625.x
31. Harper, A. and Jin, Z. (2012). Stock returns and macroeconomic factors: An examination of the Indonesian domestic economy. International Research Journal of Applied Finance, 3, 4, 426-434.
32. Hasan, M. S. (2008). Stock returns, inflation and interest rates in the United Kingdom. The European Journal of Finance, 14(8), 687-699.
33. Jaffe, J. F., & Mandelker, G. (1976). The" Fisher effect" for risky assets: An empirical investigation. The Journal of Finance, 31(2), 447-458. https://doi.org/10.1111/j.1540-6261.1976.tb01898.x https://doi.org/10.2307/2326616
34. Jareño, F., & Navarro, E. (2010). Stock interest rate risk and inflation shocks. European Journal of Operational Research, 201(2), 337-348.
35. Leibowitz, M. L., Sorensen, E. H., Arnott, R. D., and Hanson, N. (1989). A total differential approachto equity duration. Financial Analysts Journal, 45, (5), 30-37.
36. Modigliani, F., & Cohn, R. A. (1979). Inflation, rational valuation and the market. Financial Analysts Journal, 35(2), 24-44. https://doi.org/10.2469/faj.v35.n2.24
37. Nelson, C. R. (1976). Inflation and rates of return on common stocks. The Journal of Finance, 31(2), 471-483. https://doi.org/10.1111/j.1540-6261.1976.tb01900.x
38. Solnik, B. (1983). The relation between stock prices and inflationary expectations: the international evidence. The Journal of Finance, 38(1), 35-48. https://doi.org/10.1111/j.1540-6261.1983.tb03624.x
39. Williams, J. B. (1938). The Theory of Investment Value, Fraser Publishing, Cambridge: Harvard University Press