Irrelevance of inflation: the 20 Fama-French stocks

Abstract

Purpose - The relation between inflation and stock returns has been widely scrutinized. Its importance transcends finding just a simple relation, and has repercussions on the conduct of monetary policy. Theoretically, the relation should be positive and one-to-one. However, early on, the empirical relation was found to be statistically significantly negative. This paper contributes to the theoretical and empirical debate. The null hypothesis is that inflation is irrelevant to stock returns. Therefore, neither a positive theoretical, nor a negative empirical relation, should robustly hold. This position is in accordance to the basic principles of modern corporate finance, which state that the real and nominal equity values are equal. Methodology - The paper starts with simple correlations and presents the probability distributions and histograms of all variables. All distributions are characterized by significant outliers. A theoretical model that excludes inflation is introduced, and the statistical significance of including inflation is tested. The quest covers the 20 Fama-French stock portfolios, classified by their percentiles of equity values. Hence, both bilateral and multilateral regressions are carried out. Findings – Initially bilateral correlations were found to be negative consistent with the early empirical evidence. However, by using robust standard errors, robust least squares, and quantile regressions, the evidence is totally reversed. There is strong support for the irrelevance of inflation. This is true if the investor is sophisticated, i.e. she does not give too much attention to simple bilateral correlations, if she utilizes advanced economic procedures like robust least squares and quantile regressions, if she adjusts for residual autocorrelation and heteroscedasticity, and if she incorporates fundamental variables in the estimation process. Conclusion - Hence the prima facie evidence of non-neutrality is challenged by this paper’s analysis. In opposition to the conviction of many economists, and despite their inherent resistance, the paper argues for inflation irrelevance.