Inflation Effecting Stock Market Prices Finance Essay

This paper explains why the nominal level of share prices has failed to rise during a decade of substantial inflation. Many researches were conducted to demonstrate and explain the relationship between inflation and stocks returns and price earnings ratios. However this study is to look at how inflation impacts the overall stock market. This study is concerned with the structural relationship between stock market and the inflation. This paper explains why the nominal level of share prices has failed to rise during a decade of substantial inflation. The key to the explanation is the features of the current U.S. tax laws, especially historic cost depreciation and the taxation of nominal capital gains that cause the effective rate of tax or corporate source income to rise when there is a higher rate of inflation.

The current analysis shows that to understand the structural relation between inflation and share prices it is crucial to note that a high 9on~tant rate of inflation leaves the price-earnings ratio unchanged while an increase in the rate of inflation depresses the price-earnings ratio.

The higher nominal interest rates that accompany inflation actually represent lower real net-of-tax yields on alternative assets for most investors. The current analysis takes this into account in determining the share price. The main focus of the paper uses a stock valuation model to derive the share demands of investors in different tax situations and then calculates the share value that achieves market equilibrium. Numerical calculations illustrate the analysis with a representative individual and a representative tax-exempt institutional investor.

In this paper the analysis was conducted in the following area and then overall conclusion was drawn.

1) The effect of inflation on the demand prices of the shares.

2) A Market Equilibrium Model of Share Valuation.

3) Inflation and the Market Equilibrium Share Value.

After analysis the conclusion was that the higher rate of inflation causes a significant reduction in the ratio of share prices to real earnings per share. From equilibrium analysis it was also observed that the ratio of share prices to real earnings is capable to fall if the demand price of each share for some individuals is in reality increased by the effect of inflation.

The Adjustment of Stock Prices to Information about Inflation

The paper analyzes how stock prices behave in response to the news about Inflation. Relationship between inflation and common stock return is studied widely by researchers. For instance Nelson, Bodie, Jaffe and Mandelker and Fama and Schwert they all represent an evidence that there is negative relationship between the stock prices and both the unexpected and expected inflation rate since 1953 they all used monthly returns of broad group of the New York Stock Exchange common stock.

The basic idea of this paper is actually extension of the previous studies. The researcher extended the previous idea and modified it by using the daily returns of the common stocks and taking in consideration both the announcement of CPI inflation rate increase and decrease. If the unexpected inflation is bad news for the stock market, and if the announcement of CPI contains new information about inflation, if the unexpected inflation news is regarding increase of inflation rate than this news will be associated with the decrease of stock price, if the unexpected inflation news is about the deflation than the news will be associated with the increase of the stock prices. If the monthly data is used than there is a lag of more than a month between the data is collected and the actual CPI is announced to the general public. The researcher used the daily common stock returns in order to test whether the stock market reacts at the time the when the actual CPI is announced or at the time when the price data is being collected, if there is any kind of reaction.

Methodologies which were used by researchers varied from researcher or researcher, different models were used by different researchers to predict the unexpected inflation these models include:

Nelson and Bodie used extrapolative time series model to predict inflation.

Jaffe and Mandelker and Fama and Schwert followed Fama using short-term interest rate as a predictor of inflation.

The researcher used Fama's model to measure the unexpected inflation for the purpose of this study. For the assurance that the results are not distorted due to the choice of the model which is used all the tests are replicated again and using time series model to estimate the unexpected inflation.

For the purpose of this research the data which is used is the daily returns of Standards and Poor's composite portfolio from the year 1953 to year 1978. Variables of the model which was used are given below:

The daily continuously compounded rate of return on Standard and Poor's composite portfolio

Dummy variable for the day of the week.

Monthly Treasury bill rate measured at the end of the month.

Measure of expected inflation rate using Fama's model

The announcement date of unexpected inflation rate.

The findings of the paper remained that the stock market do reacts to the unexpected inflation when the CPI is actually announced; one of the strange findings was that the stock market do not react to the unexpected inflation when actually CPI is sampled, in reality several weeks before the announcement of that results to the general public. The finding remained that the stock market reacts to the information but not to the actual increase in inflation when actually this is happening.

The Effects of Inflation News on High Frequency Stock Returns

July 1999

The paper examines how stocks respond to unanticipated news regarding macroeconomic conditions i.e. Inflation. There are four basic questions to be answered by findings of the research the four questions are:

Does news about inflation impacts stock return.

Reasons behind weak link between stocks and CPI news.

Reasons for insignificant link between small stock and PPI Inflation news.

What is the intensity of response to the inflation news?

The theoretical and empirical models which are used to answer these questions are based upon the idea that "stock prices are influenced by economic announcements like if the new information affects the either the expected dividends or the expected discount rates, or the both. The new information is the difference between announced value of the inflation at t+1 time and the anticipated value of inflation at time t. in early times many researches were done on this area but in this paper the data which is used to analyze is based on monthly expected and actual inflation. In prior studies the daily data was used.

The sample data for Producer Price Index (PPI) and Consumer Price Index (CPI) are used from January 1983 to December 1995. The stock equally- weighted common stock portfolio returns are used which were created from Institute for the Study of Securities Markets (ISSM) Transactions Databases (years 1983 to 1992) and from the New York Stock Exchange's (NYSE) Trade and Quote (TAQ) database (years 1993 to 1995).

Five different regressions were ran initially for knowing the coefficients of the variables after that the results were checked against the Null Hypothesis.

PPI had negative correlation with the stock returns and the results for CPI are surprising that the relationship between CPI and the Stock Returns is statistically insignificant. The research mentioned that those who investigate the stock returns on daily return basis will miss the link between stocks and inflation. To test the impact of inflation on different sizes of the stock the researcher used the following methodology. The results were different for the different sizes of the stock the large stocks had more and clear response to the news regarding inflation as the size of the stock is reduced the link started becoming meaningless when the stock size is reduced to very low the relationship became insignificant and at extreme the signs which came were completely useless.

The conclusion answered the questions of the researcher that there is strong relationship between the unanticipated inflation (news) and the intra-day stock returns. Yes there is strong relationship between Producer Price Index (PPI) news and the stock returns however there is weak relationship between Consumer Price Index (CPI) news and the stock returns. The relationship was of inverse and the relationship was significant for large stocks and insignificant for small stocks. Answer to the second question is that as PPI is forecasted and availability of PPI news, CPI news is less frequent and most of times it is not available there the link between CPI and stock returns is weak. The response of the stock to the news takes 15 minutes to respond to the news regarding inflation

The Relationship between Stock Returns and Inflation

In Four European Markets

Summary

This paper examined the effects of both expected and unexpected inflation on real stock returns for four different European countries i.e. France, Germany, Italy, and the U.K. The literature has the evidence that there exists a negative relationship between these two variables i.e. Inflation and real stock returns, as it is evidence from the studies of Nelson, Fama and Schwert. On the other side of the picture few researchers argued strong positive relationship between inflation and the nominal returns on the stock i.e. Boudoukh and Richardson. While at the same time the other researcher claimed: either no relationship Rapach (2002) or others evidenced a little relationship Shiller (1992). This is the summary of the literature which was mentioned in the paper.

This paper examines the relationship between real stock returns and expected and expected inflation in four different European countries, however it is assumed that all the European markets are homogenous in nature. This paper is unique in the sense that it examines the relationship between both the expected and unexpected inflation.

The technique which is used in this paper is also different from those which were used in the previous papers. Four different equations were used for different variables i.e. inflation, interest rate and economic growth, all these equations are estimated using the "Box-Jenkins Methodology". First these parameters are estimated and then another equation is used to gauge the impact of these variables on real stock returns. The methodology which is used is to simultaneously estimation with full information maximum likelihood.

Data which was used for this analysis is obtained from International Financial Statistics and OECD CD-ROM. Quarterly data was analyzed from the first quarter of 1975 to first quarter of 2001.

Now the results portion of the paper: unexpected inflation and unexpected interest rates were statistically significant for three countries and had significant impact on real stock returns. France, Italy and U.K. are affected by both unexpected inflation and unexpected interest rates. The remaining variables had no significant impact on the real stock returns for these three countries. However in Germany none of the variables turned out to be significant.

The summary of the findings is that the real stock return does not respond to expected inflation but they do respond to unexpected inflation. Inflation shocks have no impact on real stocks returns but stocks do respond to these shocks in the manner which were mentioned in the literature. Finally stock returns do not tend to respond to economic growth or even shocks to economic growth.

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