RDP 9610: Share Prices and Investment 1. Introduction

Investment and share prices are closely linked in neoclassical investment models. Managers make investment decisions on the basis of whether the investment will improve the future value of the firm. As share prices are forward looking variables which condense information regarding a firm's expected value, movements in share prices and investment should, in theory, be correlated. Increasingly, however, it has been recognised that share markets may not be efficient processors of information and may deviate from their fundamental value for extended periods.^[1] Depending on the extent to which there is a causal relationship between share prices and investment, share prices which are not based on fundamentals may distort investment decisions.

There is little consensus on this issue. One strand of the literature argues that the share market is a passive predictor of future activity and that managers do not rely on share-price movements to make investment decisions. For example, Bosworth (1975, p. 286) argues that it is inconceivable that management who are concerned with the long-run market value of the firm would ‘scrap investment plans in response to the highly volatile short-run changes in stock prices’. On the other hand, there is a strand of literature which suggests that share prices provide key price signals to managers regarding corporate investment decisions (Fischer and Merton 1984). If this were the case then any pricing inefficiencies would send misleading signals to managers and would distort investment decisions. Some adherents to this view argue that even sophisticated managers who know the true value of their firm are still likely to react to non-fundamental share-price movements. For example, if managers perceive their firm to be overvalued they will take advantage of the relatively low cost of capital by issuing shares and using the proceeds to invest in capital or to improve their balance sheets (Fischer and Merton 1984; Tease 1993). If this were the case then speculative share-price moves would have real effects.

The empirical evidence of the linkage between share prices and investment is mixed. Fischer and Merton (1984) and Doan, Litterman and Sims (1983) show that once allowance is made for other determinants of investment, share prices still play a prominent role in explaining investment. In contrast, Morck, Shleifer and Vishny (1990) find only a minor role for share prices beyond their ability to predict fundamental determinants of investment.

Of the few studies which have attempted to decompose share prices into their speculative and fundamental components, Tease (1993) concludes that, to the extent that pricing inefficiencies may exist, they do not significantly influence investment. Blanchard, Rhee and Summers (1990, p. i) interpret their results as ‘pointing, strongly but not overwhelmingly, to a larger role of “fundamentals” than of “valuation” (speculation) in investment decisions’. Chirinko and Schaller (1996, p. 50) establish similar results, concluding that ‘there are bubbles in the stock market but they do not seem to affect investment’.

This paper examines the efficiency of pricing of Australian shares and the influence of share prices on investment decisions. The paper is set out as follows. Section 2 examines the theoretical linkages between share prices and investment. The literature and some empirical tests on the efficiency of share-price determination are examined in Section 3. Section 4 decomposes aggregate share prices into estimates of their fundamental and speculative components and presents empirical results from estimating investment equations. Section 5 examines the extent to which managers are able to identify and exploit speculative share-price movements. Section 6 concludes.

Footnote

See Fama (1970, 1991), Poterba and Summers (1988), De Long, Shleifer, Summers and Waldmann (1990), Cutler, Poterba and Summers (1990a, 1990b), Claessens, Dasgupta and Glen (1995) and Kortian (1995). [1]