Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis. Comment.

Stock market investors are hypothesized to suffer from money illusion, incorrectly discounting real cash flows with lower than rational, i.e. nominal, discount rates. Cohen et al. (2005) show that one implication of such an error is that higher inflation causes the market’s subjective equity-premium expectation to deviate systematically from the rational one and the risk-return relation to become inverse. In this paper, I investigate another implication of the model related to the risk-bearing capacity of investors. I hypothesize that higher inflation uncertainty makes it more likely that investors conduct the expectational error and theoretically show that in a low and stable inflationary environment, more money illusioned investors in the stock market can be associated with a higher expected return risk premium. Empirically, using an inflation uncertainty measure as a proxy for the fraction of money illusioned investors, I find that the relation between inflation uncertainty and the expected return premium of risky small cap stocks over safe large cap stocks is indeed positive. A managed equity portfolio that holds the SMB factor and takes more (less) risk when inflation uncertainty is high (low) generates a significant equity risk-adjusted alpha. Managing inflation uncertainty is in line with conventional investment wisdom, because the strategy takes relatively more risk in recessions when inflation uncertainty is high. My empirical results, therefore, further support the hypothesis that the stock market suffers from money illusion.