Asset Prices and Real Investment

This paper analyzes the links between the firms investment technology and financial asset prices within a general equilibrium production economy. The model assumes that real investment is irreversible and subject to convex adjustment costs. It shows how these basic features of real investment naturally generate rich dynamics of stock returns. Firm investment activity and firm characteristics, particularly the marketto-book ratio, or q, are functions of the state of the economy and therefore contain information about the dynamic behavior of stock returns. The model implies that the relation between real investment, q, and stock returns is conditional in nature. During low-q periods when the irreversibility constraint is binding, the relation between the conditional volatility and expected returns on one hand, and the market-to-book ratio and investment rate on the other hand should be negative. During high-q periods when the constraint on the rate of investment is binding, the relation should change sign to positive. Empirical tests based on industry portfolios are supportive of the model predictions for the behavior of conditional return volatility, but provide no evidence in favor of the implications for expected return. JEL classification: G1, D5, E2, C0