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The Stock Market, Profit and Investment

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Author Info
Olivier Blanchard
Changyong Rhee
Lawrence Summers

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Abstract

Should managers, when making investment decisions, follow the signals given by the stock market even if those do not coincide with their own assessments of fundamental value? This paper reviews the theoretical arguments and examines the empirical evidence, constructing and using a new US time series of data on the q ratio from 1900 to 1988. We decompose q - - the ratio of the market value of corporate capital to its replacement cost - - into the product of two terms, reflecting "fundamentals" and "valuation", the ratio of market value to fundamentals. We then examine the relation of investment to each of the two, using a number of alternative proxies for fundamentals. We interpret our results as pointing, strongly but not overwhelmingly, to a larger role of "fundamentals" than of "valuation" in investment decisions.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3370.

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Date of creation: May 1990
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Publication status: published as Quarterly Journal of Economics, Vol. 108, no. 1 (February 1993): 115-136.
Handle: RePEc:nbr:nberwo:3370

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  1. Marsh, Terry A & Merton, Robert C, 1986. "Dividend Variability and Variance Bounds Tests for the Rationality ofStock Market Prices," American Economic Review, American Economic Association, vol. 76(3), pages 483-98, June. [Downloadable!] (restricted)
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  2. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August. [Downloadable!] (restricted)
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  3. William C. Brainard & John B. Shoven, 1980. "The financial valuation of the return to capital," Proceedings, Federal Reserve Bank of San Francisco, pages 43-104.
  4. Jorgenson, Dale W & Yun, Kun-Young, 1986. " Tax Policy and Capital Allocation," Scandinavian Journal of Economics, Blackwell Publishing, vol. 88(2), pages 355-77.
  5. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May. [Downloadable!] (restricted)
  6. Galeotti, Marzio & Schiantarelli, Fabio, 1994. "Stock Market Volatility and Investment: Do Only Fundamentals Matter?," Economica, London School of Economics and Political Science, vol. 61(242), pages 147-65, May. [Downloadable!] (restricted)
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  7. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, vol. 50(1), pages 213-24, January. [Downloadable!] (restricted)
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