Academic journal article Journal of International Business Research

Stock Prices and Inflation: Evidence from Jordan, Saudi Arabia, Kuwait, and Morocco

Academic journal article Journal of International Business Research

Stock Prices and Inflation: Evidence from Jordan, Saudi Arabia, Kuwait, and Morocco

Article excerpt

INTRODUCTION

The relationships between stock returns and inflation rates or stock prices and goods prices have been the subject of numerous research papers during the last five decades. Mixed results were obtained ranging from no relationship, to negative and positive relationships. However, the short-term negative relationship and the Long-term positive relationship seem to be well established in the literature.

Theoretically, stocks are assumed to be inflation neutral for unexpected inflation which should have a negative effect on stock prices. The standard discounted cash flow model calculates stock prices as the present value of future expected cash flows. For stocks to be inflation neutral and represent a good long-term hedge against inflation, firms should pass on any increase in inflation rates on future cash flows. Investors on the other hand should discount the adjusted cash flows by inflation-adjusted rate of return or discount the real cash flows by the same real discount rate.

This argument is now known as the Fisher hypothesis (1930) or Fisher effect. Fisher argues that stocks are claims against real assets therefore they are neutral and uncorrelated with inflation rates. Stock returns are equal to the real rate of return plus an inflation premium. Since this is an equilibrium relationship, it is supposed to hold in the long -run. Hoguet (2009) reports that when inflation rates were historically high or accelerating in the US, price/earnings ratios were declining, a phenomenon which puzzled researchers and practioners as well.

The literature offers three theories as possible explanations for this relationship. Fisher hypothesis is more applicable in the long -run as an equilibrium relationship. The behavioral hypothesis proposed by (Modigliani & Cohn, 1979) has been used to explain the short--run relationship, or what is known today as the inflation illusion phenomena. This hypothesis says that investors mistakenly price future real cash flows by discounting by the nominal rate of return. The proxy hypothesis proposed by Fama (1981) argues that because stock returns are positively related to future real economic growth, as inflation increases, real economic growth declines and become more volatile which pushes investors to require higher risk premiums to cover the additional risk. Stock prices therefore start declining accordingly. This hypothesis is also supported by Sharpe (1999).

The debate is still ongoing although standard investment and finance theory implies that stocks are good hedging instruments at least in the long run. It is however necessary to differentiate between the effect of anticipated inflation and unanticipated inflation. While stocks should be inflation neutral, it is reasonable to assume that their prices react negatively to inflation shocks. New investors require risk premium for any increase in unanticipated inflation, and this implies a decline in stock prices. However, one should admit that investors sometimes do not follow standard investment theory because of behavioral reasons and lack of sophisticated knowledge about finance fundamentals. In markets with more and more institutional investors, the behavioral hypothesis becomes less realistic on the grounds that institutional investors are expected to be sophisticated investors.

Stocks should be good hedging assets against inflation but they are also sensitive to future changes in inflation rates. Investors may have incentives to adjust their valuation of stock piecemeal. That is, every time they are faced with new inflation rate, they make the adjustment instantaneously as if they are dealing with a short-term security with short-term investment horizon.

In this paper, we contribute further evidence on the long-run Fisher effect for stocks by using stock prices and goods prices. Consistent with Engle and Granger (1987), this approach allows us to fully use long-run information contained in the levels of the variables, as opposed to focusing on partial long-run information contained in selected holding periods. …

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