July 26, 2012/ Douglason G. Omotor / Journal of Applied Statistics

The last two decades have been a tranquil for the Nigerian economy. Inflation rate for example, rose markedly in the fourth quarter of 2008 reaching a 3-year high of 15.1 per cent in December from its single digit level of 7.8 per cent at end of March, 2008. Precisely, the inflation rate was 6.5 per cent in December 2007. The inflationary pressure which continued into 2009 as some sources have it (notably the Central Bank of Nigeria, 2009), may have been attributed to rising food prices, inefficient and poor transport services, port congestion, depreciation of the naira and the rush to spend budgetary allocations by government agencies before fiscal year end (Sampson, 2009).

During the same periods, the Nigerian capital market experienced a bullish trend when it started the year 2008 at 58,580 (with a market capitalization of N10.284 trillion), and went on to achieve its highest value ever of 66,371 on March 5, 2008,with a market capitalization of about N12.640 trillion (Aluko, 2008). The capital market has since the March 5 to October, 2008 lost about N3.38 trillion, over 26.7 percent; as market capitalization stood at N9.11 trillion. Nigeria equally faced a major decline in portfolio equity flows perceived to be correlated with the sharp fall in stock market. For instance, foreign portfolio investors withdrew $15 billion from the Nigerian capital market in January 2009 (Ajakaiye and Fakiyesi, 2009). The All Share Index (ASI) consequently shred a total share of 67 per cent from March 2008 to March 2009.

In attempt to find some reprieves for the continuous bearish trend in the market, the Central Bank of Nigeria took over the management team of 8 commercial banks effective from August 14, 2009 as the illiquidity in the capital market dove-tailed into the money market. The action described as a hybrid attempt to restructure these banks as a result of their debt exposure to the capital market is beginning to have its toll on the average general price level as analysts speculate precautionary cash balances. One puzzle left to be answered is if the sharp movements in general prices (inflationary) during these years have any linkage with the bullish/bearish capital market dominated activities before and after the 2008 crash.

This paper investigates the relationship between inflation and stock market returns using Nigerian data. Specifically, we effect the analysis by exploring the distinct impacts of inflation on the stock market returns at different time horizons, and also test the Fisher hypothesis by examining the relationship between, (b) contemporaneous inflation and stock market returns, and (c) between inflation and money on the one hand, and between inflation and real activity on the other. The outcomes of the analyses are expected to be of immense importance to investors particularly, in reaching rational decisions on asset allocation and advancement of the literature on financial economies.

The rest of the paper is organized as follows: the next sections briefly review some related literature and presents the historical perspective and performance of Nigerian capital market. Section 4 presents the model, data sources and measurements. Section 5 discusses the results. Section 6 explains the role money and economic activity played in the inflationary process, while the last section concludes the paper.