This paper empirically investigates the relationship between real stock returns, inflation, and real activity using the Markov-switching dynamic regression (MS-DR) approach. The MS-DR allows multiple structural breaks in the estimation, and we can check regression coefficients separately in the recession and expansion periods. We selected two major developing countries (Mexico and South Africa) in order to reduce location bias. We use real stock returns, expected inflation, unexpected

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... and real GDP growth in the estimations, and the ARFIMA model is used for unexpected inflation. The empirical results show that the relationship between real stock returns and inflation is negative only in the recession period. This regime-dependency is also tested with Eugene F. Fama's (1981) proxy effect hypothesis, and it is found that the stock returns respond differently to inflation in a regime according to the regime-dependent proxy effect hypothesis. These findings suggest that the negative relationship puzzle in the empirical finance literature can be explained with the regime-dependency effect. tive only in the recession period. This regime-dependent negative relationship is also tested with Fama's (1981) proxy effect hypothesis, and it is found that the stock returns respond differently to inflation in a regime, according to the regime-dependent proxy effect. These findings suggest that the negative relationship puzzle in the empirical literature can be explained with the regime-dependency between real stock returns, inflation, and real activity. The remainder of this paper is organised as follows. The next section reviews previous literature on the Fisher and the proxy effect hypotheses. The methodology of the MS-DR approach is presented in the second section. In the third section, the data is presented and empirical results are discussed. The summary is presented in the final section.