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Abstract
If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.
I. Introduction
Beginning in August 1982, the U.S. stock market experienced one of the longest bull markets in history. From August 1982 to December 1999, the compounded real total return on the Dow Jones Industrial Average was 15% per year, far in excess of the increase in earnings or book value. Explanations that the academic literature has focused on for the rise in price-earnings and market-to-book ratios include improved earnings growth prospects and a decrease in the equity risk premium. While we believe that both of these factors have played a significant role in the bull market, we argue, using the hypothesis originally suggested by Modigliani and Cohn (1979), that the early stages of the market runup were partly attributable to a recovery from inflation-induced valuation errors. Specifically, investors commit two errors in valuing equities: they capitalize real cash flows at nominal rates, and they fail to recognize the capital gain that accrues to the equity holders of firms with fixed dollar liabilities in the presence of inflation. We propose that these two errors result in substantial undervaluation of equities when inflation is high, as in the early 1980s. The bull market that we have seen is in part a correction from this previous level of undervaluation.
We develop a measure of intrinsic value using a residual income model that adjusts for inflation-induced distortions in accounting income. When compared to the stock price, this provides a measure of misvaluation. In cross-sectional regressions, we find that the amount of undervaluation...