Historical Inflation and Stock Value Experience
The experimental evidence denies the status of stocks as a good hedge against inflation. A study conducted by Ibbotson and Brinson in 1987 confirms this fact. Table 2 presents their findings which is depicted in two parts. The first part includes yearly inflation readings which are then placed in one of the six groups defined as extraordinary deflation (-4% and below) to extraordinary inflation (8% and above). The concurrent year's average stock market return has been shown in the second column. Table 2 indicates the findings for the post World War II era and a long-term experience. Clearly, the table indicates that exceptionally high inflation rates are not conducive for the common equity. It is also visible from the table that during the periods of stable price and modest inflation, common stock produced returns were a little higher than those generated during the unusual deflationary periods. However, in real terms, the returns produced by common stocks during these two situations were quite close to each other.
The relationship of stocks returns with rising and declining inflation rates have been shown in the second part of the table. The results presented in nominal terms are very significant. The nominal stock returns registered during the 31-year period of rising inflation (at least 5 percent or more) were not more than 3 percent. However, during the periods of rapidly declining inflation rates, gains above 11 percent were attained. The interrelation between inflation and stock price changes was the favorite topic for academic studies. This was further stimulated by the development of the Center for Research on Security Prices (CRSP) data files in the 1960s and the extraordinary high inflation experienced in 1960. Various researches have been conducted and hence theories were established to deduce the relationship between the stock price return and the inflation rate. These theories were described with different names such as real output, investor rationality and nominal contracting. Modigliani and Cohn proposed the investor rationality hypothesis in 1979. Their theory suggests that investors generally misjudge the rates of inflation during the period of high inflation. This happens probably because they always try to find out the correlation between the nominal interest rates with earning yields for the stock market. For instance, if an investor believes that the rate of inflation has moved from 4% to 5%, the important thing that an investor would like to know will be the impact of this change on the stock market prices. According to the Modilgliani and Cohn hypothesis, an investor will accordingly increase the inflation premium in the discount rate of bond and stock market and this will change two things. First, the increase in the discount rate will diminish the present value of the stocks as well as bonds in the standard valuation model. The second effect will be observed because of this lower present value. The bond and earning yields of the stock market will increase because of the lower present value of these assets. In addition to this, Modigliani and Cohn irrationality hypothesis states that the analysis should be carried even after fixed income bond adjusts with one percent increase in yield to balance one percent rise in the inflation premium. However, the stock market may not change like the bond market. It can be safely believed that, if the investors fully conced the increased inflation in the form of product and service price rise, the cash flow they receive in the standard valuation model should rise suitably to completely compensate the increase in the inflation rates and therefore no change can be expected in the present value and the current yields. Modigliani and Cohn again argued that an investor could not reduce the value of the corporate nominal liabilities. They further added that, if investors were busy in estimating stocks on an asset value or balance sheet basis, the above said argument would create a valuation problem. Generally, asset valuation requires estimating the value of the assets and liabilities. The equity value can be calculated as the residual value. Use of the asset valuation approach is not inconsistent and can be used in place of the standard valuation model. By using the two valuation methods we can see the equity value of the same firm in two ways.