The Stock Market and Investment: Is the Market a Sideshow?

Abstract

The Stock Market and Investment: I s t he Market a Sideshow? RECENT EVENTS and research findings increasingly suggest that the stock market is not driven solely by news about fundamentals. There seem to be good theoretical as well as empirical reasons to believe that investor sentiment, also referred to as fads and fashions, affects stock prices. By investor sentiment we mean beliefs held by some investors that cannot be rationally justified. Such investors are sometimes referred to as noise traders. To affect prices, these less-than-rational beliefs have to be correlated across noise traders, otherwise trades based on mistaken judgments would cancel out. When investor sentiment affects the demand of enough investors, security prices diverge from fundamental values. The debates over market efficiency, exciting as they are, would not be important if the stock market did not affect real economic activity. If the stock market were a sideshow, market inefficiencies would merely redistribute wealth between smart investors and noise traders. But if the stock market influences real economic activity, then the investor sentiment that affects stock prices could also indirectly affect real activity.

Three Essays on Growth Econometrics

“…For each specification, in the first row we report the R 2 of the specification with only firm-specific fixed-effects. These have been found to explain the bulk of the variation in investment (Rhee and Rhee, 1995;Morck et al, 1990). In the second row we add our measure of average Q or marginal Q, report its coefficient and assess the change in R 2 to get at the incremental explanatory power of a given Q measure.…”

“…Morck et al (1990) Unfortunately, in almost none of the above analyses it is transparent how much of the total variation is explained by average Q versus the constant or fixed effect or versus other variables that are included in the regressions. There are a few exceptions to this.…”

“…11 See the CRSP guidelines at: http://www.crsp.com/products/documentation/data-definitions-p 12 This is a commonly used measure of investment in the literature on firm investment. See, e.g., Morck et al (1990); Polk and Sapienza (2009).…”

“…Studies find that Tobin Q's ability to predict firm investment is generally weak, with the dominant contribution to the R 2 's stemming from firm-fixed effects (e.g., Morck et al, 1990). …”

“…However, if the stock market is inefficient, driven, e.g., by human emotion (fads and fashions) (Shleifer, 2000;Morck et al, 1990), then stock markets may not reflect fundamentals (Stein, 2003), potentially explaining Tobin Q's poor performance. Indeed, Morck et al (1990) find that the stock market does not capture any information over and above fundamentals, such as cash flow and sales variables, and conclude that the stock market is essentially a sideshow in terms of its influence on investment. However, discounted cash flow models may percentage points of the R 2 's.…”