Stock Prices, Inflation and the Out-of-Sample predictability of Stock Market Returns

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 out-of-sample forecasting abilities for real stock 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.