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Inflation Illusion and Post‐Earnings‐Announcement Drift
Author(s) -
CHORDIA TARUN,
SHIVAKUMAR LAKSHMANAN
Publication year - 2005
Publication title -
journal of accounting research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 6.767
H-Index - 141
eISSN - 1475-679X
pISSN - 0021-8456
DOI - 10.1111/j.1475-679x.2005.00181.x
Subject(s) - economics , earnings , inflation (cosmology) , stock (firearms) , monetary economics , earnings growth , post earnings announcement drift , illusion , earnings response coefficient , econometrics , financial economics , finance , biology , physics , theoretical physics , mechanical engineering , neuroscience , engineering
This paper examines the cross‐sectional implications of the inflation illusion hypothesis for the post‐earnings‐announcement drift. The inflation illusion hypothesis suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rates, and this causes firms whose earnings growths are positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns, and earnings announcement returns of SUE‐sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the ability of lagged SUE to predict future returns of SUE‐sorted stocks.