Stock Prices, Inflation and Stock Returns Predictability

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This paper considers a new perspective on the relationship between stock prices and inflation, by estimating the common long-term trend in real stock prices, as reflected in the earning-price ratio, and both expected and realized inflation. We study the role of the transitory deviations from the common trend in the earning-price ratio and realized inflation for predicting stock market fluctuations. In particular, we find that these deviations exhibit substantial insample and out-of-sample forecasting abilities for both real stock returns and excess returns. Moreover, we find that this variable provides information about future stock returns at short and intermediate horizons that is not captured by other popular forecasting variables.