Inflation and Real Stock Returns: The Channels of Influence

This paper examines the observed inverse relationship between inflation and real stock returns. Using a sample partitioning of the 1954-87 period, we show that the 1965-73 period appears most responsible for this anomaly. We show that Fama's [1981] proxy hypothesis is inadequate during this period. As an alternative line of investigation, we develop measures of economic earnings and the earnings multiple and examine their relationship with unanticipated inflation. We find a significant inverse relationship between unanticipated inflation and an economic definition of real earnings. In addition, we find a significant positive relationship between unanticipated inflation and the capitalization rate on earnings. Both of these findings are consistent with the observed inverse relationship between unanticipated inflation and real stock returns, and suggest that the channel of unanticipated inflation's influence on real stock returns runs through the relationship between unanticipated inflation and fundamental determinants of stock returns.