Innovation Waves, Investor Sentiment, and Mergers

We develop a theory of innovation waves, investor sentiment, and merger activity based on uncertainty aversion. Investors must typically decide whether or not to fund an innovative project with very limited knowledge of the odds of success, a situation that is best described as "Knightian uncertainty." We show that uncertainty-averse investors are more optimistic on an innovation if they can also make contemporaneous investments in other innovative ventures. This means that uncertainty aversion makes investment in innovative projects strategic complements, which results in innovation waves. We also show that innovation waves may be sparked by favorable technological shocks in one sector, and then spill over to other contiguous sectors. Thus, innovation waves ripple through the economy amid strong investor sentiment. Finally, we argue that an active M&A market promotes innovative activity and leads to greater innovation rates and firm valuations.