EVIDENCE THAT THE COMMON STOCK MARKET ADJUSTS FULLY FOR EXPECTED INFLATION

Inflation has become a major concern for financial managers in recent years because of its effects on company performance. For managers attempting to maximize company value an understanding of how stock prices respond to inflation is of utmost importance. Stock price may be viewed as the sum of cash flows to stockholders discounted at the required rate of return. Therefore, and understanding of how inflation affects cash flows and required return is necessary for the understanding of how stock prices react to inflation. Considerable attention has been given to the effects of inflation on cash flows to the stockholders.' Unfortunately, the same cannot be said about the response of required rate of return to inflation. Studies of the response of common stock returns to inflation may be classified into two types. The majority are those concerned with realized returns and whether common stocks are hedges against inflation, e.g., Ibbotson Sinquefield [11] and Reilly [26]. In general, they have shown that common stocks are not complete inflation hedges. The second type deals with required returns and whether they can be explained by the Fisher effect. Works of this type include Jaffee and Mandelker [12], Lintner [19, 20], Nelson [23] , and Oudet [24]. In contrast to studies of the bond market, these studies have failed to show the existence of the Fisher effect in the common stock market. This paper is concerned with the second type of problem. Fisher [8] posited that the ex ante return on an asset must fully reflect the ex ante inflation rate. In symbols: * R = r + I