Inflation Illusion and Post-Earnings-Announcement Drift

Authors


  • We thank Eli Amir, Ray Ball, Sudipta Basu, Michael Brennan, Greg Clinch, Paul Irvine, Ken Peasnell, Shivaram Rajgopal, Abbie Smith, Mohan Venkatachalam, an anonymous referee, and seminar participants at Cranfield University, Case Western University, London Business School, Duke University, Vanderbilt University and London Business School Accounting Symposium for helpful comments. The second author was supported by the Dean's Fund for Research at the London Business School. All errors are our own.

ABSTRACT

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.

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