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Do Bubbles Lead to Overinvestment?: A Revealed Preference Approach

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  • Robert S. Chirinko
  • Huntley Schaller

Abstract

Many economists believe that the stock market plays an important role in efficiently allocating capital to its most productive uses. This standard story of the stock market was called into question by events in the late 1990s, when some observers believed that stock market overvaluation – or a bubble - led to overinvestment. Both the standard and overinvestment stories involve discount rates and, to differentiate between the two stories, this paper examines the discount rates used by firms in making their investment decisions.We use a revealed preference approach that relies on the pattern of investment spending – combined with investment theory – to estimate the discount rates used by managers. The standard story predicts that firms with high stock prices and good investment opportunities should have discount rates that do not differ systematically from the risk-adjusted market rate. The overinvestment story predicts that firms with high stock prices and poor investment opportunities should have discount rates consistently below the market rate.Based on a panel dataset of over 50,000 firm-year observations, we find support for both stories. The behavior of high stock price firms with good measured investment opportunities is best described by the standard story, while the overinvestment story provides the most appropriate interpretation of the behavior of high stock price firms with poor investment opportunities. Firms in this latter category accumulate between 15.1% and 45.2% too much capital. These estimates suggest that, even before they burst, bubbles adversely affect economic activity by misallocating capital.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3491.

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Date of creation: 2011
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Handle: RePEc:ces:ceswps:_3491

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Related research

Keywords: bubbles; investment; stock markets; real effects of financial markets; capital formation;

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References

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  1. Stein, Jeremy C, 1996. "Rational Capital Budgeting in an Irrational World," The Journal of Business, University of Chicago Press, vol. 69(4), pages 429-55, October.
  2. Huntley Schaller & Robert S. Chirinko, 1995. "Business Fixed Investment and "Bubbles": the Japanese Case," Carleton Economic Papers 95-13, Carleton University, Department of Economics, revised 2001.
  3. Maureen O'Hara, 2008. "Bubbles: Some Perspectives (and Loose Talk) from History," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 11-17, January.
  4. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272, September.
  5. Malcolm Baker, 2009. "Capital Market-Driven Corporate Finance," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 181-205, November.
  6. Chirinko, Robert S. & Schaller, Huntley, 2003. "A Revealed Preference Approach. To Understanding Corporate Governance Problems: Evidence From Canada," Economics Series 135, Institute for Advanced Studies.
  7. Chirinko, Robert S. & Fazzari, Steven M. & Meyer, Andrew P., 1999. "How responsive is business capital formation to its user cost?: An exploration with micro data," Journal of Public Economics, Elsevier, vol. 74(1), pages 53-80, October.
  8. Whited, Toni M, 1992. " Debt, Liquidity Constraints, and Corporate Investment: Evidence from Panel Data," Journal of Finance, American Finance Association, vol. 47(4), pages 1425-60, September.
  9. Lakonishok, Josef & Shleifer, Andrei & Vishny, Robert W, 1994. " Contrarian Investment, Extrapolation, and Risk," Journal of Finance, American Finance Association, vol. 49(5), pages 1541-78, December.
  10. Schaller, Huntley, 2006. "Estimating the long-run user cost elasticity," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 725-736, May.
  11. Utpal Bhattacharya, 2008. "The Causes and Consequences of Recent Financial Market Bubbles: An Introduction," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 3-10, January.
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