Inflation illusion and stock returns

• We quantify individual stock's sensitivity to inflation illusion by measuring how its earnings yield related to inflation.
• We create an inflation illusion factor by buying stocks that are more sensitive to inflation illusion and sell stocks that are less sensitive to inflation illusion.
• The inflation factor is significant in pricing portfolios formed on asset growth, investment and the book-to-market ratio.
• Low asset growth stocks have large exposure to the inflation illusion factor and are underpriced at times of high inflation.

A large sensitivity of stocks' earnings yield to inflation suggests that the value of these stocks is highly influenced by inflation illusion. We construct an inflation illusion factor by buying stocks with large earnings yield sensitivities on inflation and selling stocks with small earnings yield sensitivities on inflation. This factor has a return of approximately 5% per year and is priced in the cross sectional asset returns. Low asset growth stocks have greater exposure to the inflation illusion factor than their counterparts, and they are also underpriced at times of high inflation. Our results are robust for a number of controls.