How information from stock prices drives capital misallocation during recessions
In this paper, Bostanci and Ordoñez build a stock market model in which both the information content and the noise in prices respond to changes in economic activity endogenously, affecting how well those prices reflect a firm’s performance. They incorporate the stock market into a dynamic model with heterogeneous firms to characterize how stock price informativeness and capital misallocation interact with one another. Finally, they estimate the model by constructing a firm-level panel data from 57 countries that combines stock prices and earnings forecasts. A shock that increases liquidity traders’ share in the economy masks the information about fundamentals in prices. This mechanism raises two real distortions:
- Increased spending on acquiring costly information by traders which allocates resources away from productive capital and towards information producing;
- Worse allocation of capital across firms by the investors which causes a misallocation of capital across firms and leads to lower aggregate investment.
Hence a financial shock that increases the liquidity needs increases misallocation, decreases aggregate investment, and increases the resources spent on information production, consistent with the patterns observed during recessions.
Price Informativeness and Business Cycle Misallocation
Authors: Gorkem Bostanci, Guillermo Ordoñez
From: University of British Columbia, University of Pennsylvania
How investors’ demand drives capital misallocation
There have been dramatic valuation episodes that are often attributed to sentiment-driven demand from investors who favor specific stocks despite the mismatch between valuations and fundamentals. In this paper, Choi et al. analyze how such demand affects capital allocation across firms. They estimate a dynamic model, where firms make optimal investment and financing decisions facing capital provision that arises from investor demand for firms’ equity. The key feature of this setting is the direct incorporation of time-varying demand from investors. This framework enables the estimation of firms’ optimal financial responses such as share issuance and repurchases, dividend payout, and cash holdings as well as investing policies.
Our estimation suggests that investor demand is an important driver of misallocation, compared with financial and real frictions and heterogeneous risk premia. Eliminating excess demand reduces dispersion in the marginal product of capital by 23.8% and productivity losses by 22.3%. […] Our results suggest that financial market power and excess investor demand also contribute to the rise in cash stockpiling and the emergence of superstar firms in the economy.
Investor Demand, Firm Investment, and Capital Misallocation
Authors: Jaewon Choi, Xu Tian, Yufeng Wu, Mahyar Kargar
From: University of Illinois at Urbana-Champaign, University of Georgia
