TAILIEUCHUNG - Reexamining Stock Valuation and Inflation: The Implications of Analysts’ Earnings Forecasts

Both financial market participants and policymakers, such as central banks, closely follow financial market developments. However, the motivation for their interest in the financial markets differs in the sense that investors monitor asset price movements to optimize the risk-return profile on their investments, whereas central banks use financial market prices to infer information about market ex- pectations of economic growth and inflation. | Reexamining Stock Valuation and Inflation The Implications of Analysts Earnings Forecasts Steven A. Sharpe Division of Research and Statistics Federal Reserve Board Washington . 20551 202 452-2875 202 452-3819 fax ssharpe@ July 2000 Original draft January 1999 The views expressed herein are those of the author and do not necessarily reflect the views of the Board nor the staff of the Federal Reserve System. I am grateful for comments and suggestions provided by Mark Carey Paul Harrison and Nellie Liang and participants at the 1999 UCLA Equity Premium Conference and participants in the University of Michigan money macro seminar. I am particularly indebted to Chairman Alan Greenspan for his insights and suggestions during the formative stages of this research. Excellent research assistance was provided by Dimitri Paliouras and Richard Thornton. A Reexamination of Stock Valuation and Inflation The Implications of Analysts Earnings Forecasts Abstract This paper examines the effect of inflation on stock valuations and expected long-run returns. Ex ante estimates of expected long-run returns are constructed by incorporating analysts earnings forecasts into a variant of the Campbell-Shiller dividend-price ratio model. The negative relation between equity valuations and expected inflation is found to be the result of two effects a rise in expected inflation coincides with both i lower expected real earnings growth and ii higher required real returns. Surprisingly the earnings channel mostly reflects a negative relation between expected inflation and expected long-term earnings growth. The effect of expected inflation on required long-run real stock returns is also substantial. A one percentage point increase in expected inflation is estimated to raise required real stock returns about one percentage point which on average would imply a 20 percent decline in stock prices. But the inflation factor in expected real stock returns is also in long-term Treasury yields

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