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Asset Prices and the Fundamentals: A Q Test

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  • Roger Craine.
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    Abstract

    This paper presents a test of the relationship between financial asset values and the fundamentals. The test is an indirect test based on Tobin's (1969) q model of investment. The advantage of this test is that it avoids conditioning on a specific model of equilibrium returns by substituting an observable proxy, capital, for the unobservable fundamental value of the firm. Section 1 of this paper shows that under mild restrictions the value of capital and the financial value of the firm should move together even if marginal or average q does not accurately describe the actual investment decision rule. Average q is a mean reverting process. Section 2 of the paper presents the results of tests for violations of the mean reversion restriction. The tests cannot reject the unit root null hypothesis for a long annual sample from 1926 through 1988 or a quarterly post WWII sample. Section 3 examines the power of the tests with Monte Carlo simulations. The simulations show that the tests have good power until the serial correlation in the series gets quite high. The tests cannot distinguish between no mean reversion and very slow mean reversion. The empirical evidence presented in this paper provides fairly strong evidence against the hypothesis that the financial and real values are closely linked in the short run or even in the medium run.

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    Bibliographic Info

    Paper provided by University of California at Berkeley in its series Economics Working Papers with number 93-214.

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    Date of creation: 01 May 1993
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    Handle: RePEc:ucb:calbwp:93-214

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