Inflation vs. Stock Market (Part 2)
Money Illusion

People see what they want to see and what people want to see never has anything to do with the truth.
Roberto Bolaño

We continue our article on inflation and the stock market. In the first part, we talked about inflation in general terms. This time we will see if it has any relationship with the stock market, more precisely as Robert Shiller mentioned in Irrational Exuberance (2010): “people widely believe that the inflation rate is a barometer of the economic and social health of a nation… It is not surprising, therefore, that a lower inflation rate boosts public confidence, hence stock market valuation”

Curiously, from a rational perspective, this reaction of the stock market to inflation is not correct. We must consider that our behavior is sometimes not logical and is not rational, even though economic theory indicates the exact opposite. This time, we will not talk in detail about the stock market, but we will go directly to the relationship it has with inflation. We will talk about the money illusion.

Money Illusion

Until you make the unconscious conscious, it will direct your life and you will call it fate.
Carl Jung

William Shakespeare wrote in “The Merchant of Venice” (16th-century) a phrase that currently is a popular saying: “all that glitters is not gold”, which means that things sometimes are not what they seem to be. In the markets, there is a phenomenon that tells us exactly the same.

Franco Modigliani together with Richard Cohn, wrote in 1979 a paper entitled “Inflation, Rational Valuation and the Market”, where they indicated that the stock market reacts incorrectly to inflation, because people do not understand the scope of inflation over interest rates. Thus, when inflation is high, nominal interest rates (those that you see every day on the internet or in the newspapers) are also high since they must compensate investors for the lower value of their investments caused by inflation itself. However, real interest rates (adjusted for the effect of inflation) are not high. Thus, the market should not react to high nominal interest rates.

To better understand the concept, we leave you this video prepared by the Wall Street Journal, where a magician explains the money illusion.

However, the market tends to get depressed when nominal interest is high, even if real interest is not. This is defined as Money Illusion, which is public confusion due to the effects of a changing monetary pattern. How does this work? Simple. When there is inflation, the purchasing value of current money changes, also changing the measurement pattern of values or prices.

A persistent illusion

The distinction between the past, present and future is only a stubbornly persistent illusion.
Albert Einstein

Robert Shiller (2000) points out in this regard that “Public misunderstanding about inflation at the present time encourages high expectations for real (inflation-corrected) returns”

There is a great responsibility on the media, as they disseminate information about past long-term returns in nominal terms and not in real terms, spreading the confusion created by money illusion. Given this, the population tends to expect that these returns (no longer distinguishing between nominal or real) will be repeated in the future.

Some investment agents also do not help people change this way of thinking, as we observed in the article Skill vs. Luck (Part 3).

Furthermore, the majority of the population has no knowledge of economics or finance, because they have never studied these topics; and sometimes, those who have studied them, forget part of what they have learned, especially this which is basic: It is not logical to measure prices in a currency when that currency is and has been unstable, that is, when there has been inflation, therefore, you cannot compare a nominal value with a real one. This lack of economic and financial education is essential.

Shiller (2000) concludes by stating that “The public at large does not fully appreciate that the more meaningful measure of the stock market level is in terms of some broad basket of goods, as the level is measured if it is corrected for consumer price inflation”

Therefore, this popular correlation between inflation and market performance, or between inflation and the nation’s economic and social health, is incorrect. Although there are many more variables to simplify it only in this. However, for so many years it has been thought so, that it is already part of the collective unconscious as a popular knowledge that is incorrect.

We are Steering Bird, online consultants in business administration and finance. We specialize in business analysis, control and analysis of investment projects, results analysis, processes of budget and forecast, etc.

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