Investment Plans and Stock Returns

When the discount rate falls, investment should rise. Thus with time-varying discount rates and instantly changing investment, investment should positively covary with current stock returns and negatively covary with future stock returns. Aggregate nonresidential U.S. investment contradicts both these implications, probably because of investment lags. Investment plans, however, satisfy both implications. These investment plans, from a U.S. government survey of firms, are highly informative measures of expected investment and explain more than threequarters of the variation in real annual aggregate investment growth. Plans have substantial forecasting power for excess stock returns, showing that time-varying risk premia affect investment. A BASIC IDEA IN ECONOMICS and finance is that when the discount rate falls, investment should rise. If discount rates move over time and investment instantly adjusts, then the idea has two implications. First, investment and stock returns should positively covary over time. This positive contemporaneous covariation occurs because when discount rates fall, firms increase investment ~since the hurdle rate on investment falls! and stock prices rise ~since the discounted sum of future cash f lows rises!. Second, investment and future stock returns should negatively covary over time. This negative covariation occurs because when discount rates are low, investment today is high and future expected returns are low. Post-war annual aggregate U.S. data on stock returns and nonresidential investment growth contradict these implications. Investment and stock returns have a significant negative contemporaneous covariation, and investment and future stock returns have a covariation that is not statistically different from zero. The significant negative contemporaneous covariation is particularly puzzling since it seems to suggest that firms perversely cut investment when stock prices go up. * University of Chicago and NBER. I thank the Center for Research in Security Prices, the FMC Faculty Research Fund at the Graduate School of Business, University of Chicago, and the National Science Foundation for financial support. I thank Amy C. Ko, Lawrence Leung, David Robinson, and Eric Wang for research assistance. I thank Jason Abrevaya, Malcolm Baker, Simon Gilchrist, Charles Himmelberg, Anil Kashyap, Jeremy Stein, René Stulz, an anonymous referee, workshop participants at the American Economic Association meetings, Bank of England, NBER Corporate Finance meeting, University of Chicago, and the University of Wisconsin, and especially John Cochrane for helpful discussions. THE JOURNAL OF FINANCE • VOL. LV, NO. 6 • DEC. 2000