Abstract
In 1979, in a pioneering work in behavioral finance, Franco Modigliani and Richard Cohn showed that investors tend to undervalue firms in inflationary times if they do no properly account for the effects on a company9s income statement. They termed this effect “money illusion.” Here the authors examine a corollary of the Modigliani-Cohn result: In the presence of “money illusion,” the correlation between stock and bond returns will be abnormally high during periods of high inflation. For the United States, the authors show that inflation had exactly this effect on the stock/bond correlation during the postwar era. These results are useful to anyone who wants to forecasts the correlation between stocks and bonds, as essential ingredient in asset allocation.
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