Working Paper: NBER ID: w3370
Authors: Olivier Blanchard; Changyong Rhee; Lawrence Summers
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.
Keywords: stock market; investment; fundamentals; q ratio
JEL Codes: E22; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fundamentals (Y20) | investment decisions (G11) |
| market valuation (G10) | investment decisions (G11) |
| q ratio (C21) | investment decisions (G11) |
| fundamentals (Y20) | q ratio (C21) |
| market valuation (G10) | q ratio (C21) |
| investment decisions (G11) | market crashes (G01) |
| market crashes (G01) | investment decisions (G11) |