We study investors’ perceptions of inflation through the lens of a high-frequency event study, documenting they have a stagflationary view of the world. In response to higher-than-expected inflation, investors expect firms' nominal cash flows to remain stagnant while discount rates increase, resulting in lower stock prices. Both the equity risk premium and nominal risk-free yields rise, but longer-term real yields remain unchanged. Consistent with investors interpreting inflation as a cost shock, investors expect firms with low market power to suffer larger declines in cash flows. Cash flow expectations of equity investors are aligned with those of professional earnings analysts.

We examine a perplexing phenomenon wherein technological innovations induce short-term contractions, using a two-sector New-Keynesian model. Pivotal to explaining the evidence are sticky prices, which alter the cyclicality of relative prices, impacting production during innovative phases. The model addresses key asset-pricing questions: Why is there a negative link between investment returns and stock returns? Why do valuations surge post adverse labor-market events? Why do both high book-to-market and high gross-profits forecast future returns positively, despite their divergent ties to technology? Why is the slope of the equity yield term structure procyclical? The mechanism of innovation-led contractions serves as a unifying thread, weaving together previously isolated puzzles, while offering a novel perspective.

The literature has asserted that as few as four or five factor principal components (PCs) are sufficient to largely explain the cross-section of stock returns. By allowing for time variation in factor premia, we show that portfolios formed from factor PCs yield economically large out-of-sample Sharpe ratios that increase as up to forty PCs are employed. That is, non-latent time-varying factors have strong predictive power for the cross-section of stock returns, and to a substantial extent are not redundant of each other. Time variation in the number of economically relevant factors is related to changes in economic conditions and the diversity of firm characteristics, indicating roles for economic complexity and investor learning.