“The effects of noise on the world, and on our views of the world, are profound”
Fluctuations in asset prices are caused by fundamental shocks (news about future cash flows) and non-fundamental shocks (e.g. transient shifts in the demand for or supply of assets). There is ample evidence of such non-fundamental shocks. Some last for very short periods (such as the ‘mini flash crash’ of May 2010 in the US) while others can take several months to be corrected, as is the case, for instance, for price dislocations following mutual fund fire sales (e.g. Coval and Stafford 2007). These shocks inject ‘noise’ in asset prices, that is, random deviations of prices from their fundamental values (Black 1986).
Why noise in stock prices can affect corporate investment: Agency, financing, and signalling channels
Should policymakers and regulators worry about the noise in asset prices? The answer to this question depends on whether this noise matters for real economic activity (e.g. corporate investment), or whether it is just a ‘side-show’ that only redistributes wealth across a small class of winning and losing investors.
In theory, there are three possible reasons why prolonged deviations of asset prices from their fundamental values (mispricings) could affect corporate investment (Morck et al. 1990). First, the mispricing of a firm might be due to investors’ irrational beliefs (either over-optimism or pessimism) about its future prospects. In this situation, due to agency problems, managers might select their investment to ‘cater’ to investors’ sentiment rather than to maximise the long-run value of firms. For instance, managers might choose investments that are the ‘darlings’ of investors, even though their actual net present value is negative.
Second, temporary mispricings might also affect the investment of financially constrained firms, even in the absence of agency problems. Intuitively, an increase in a firm’s stock price relative to its fundamental value enables managers to issue equity at a ‘cheap’ cost, effectively relaxing leverage constraints. In this situation, investors’ irrational optimism enables financially constrained firms to issue equity to finance positive net present value investments that otherwise could not be undertaken due to financing frictions.
Common to these agency and financing channels is the assumption that managers have more information than investors to assess the value of their investment projects. That is, asset prices convey no useful information to managers. A more plausible assumption is that managers themselves have imperfect information about the payoffs of their investment projects and that some investors may have private information about these payoffs unknown to managers. In this case, managers can use stock prices as one of the myriad of signals that guide their investment decisions. There is indeed growing evidence suggesting that patterns in corporate investment are in part explained by the influence of stock prices on managers’ beliefs (see Bond et al. 2012 for a survey). In this case, noise in stock prices can affect corporate investment because it influences managers’ beliefs about the prospects of their investment projects.
For instance, consider an oil-producing company that announces plans to develop operations into the renewable energy sector and suppose that its stock price reacts negatively to this announcement.1 This drop might be due to sales of expert investors with negative signals about the ability of the firm to enter into the market for renewable energy. Alternatively, it might be due to noise, i.e. factors unrelated to the impact of the firm’s strategic plan on its fundamentals. If managers cannot perfectly distinguish fundamental from non-fundamental variation in their stock price (i.e. noise from information), they must assess the likelihood of each possible scenario. If the likelihood of the first one is high enough, they might postpone their expansion plans into renewables or even cancel them. Doing so is rational but might prove to be a mistake ex post if the decline in the firm’s stock price following its announcement was indeed due to noise. In sum, if managers use information from stock prices in making their decisions, stock prices can sometimes provide ‘faulty signals’ (Morck et al. 1990).
Evidence that stock prices can be faulty signals for managers
In a recent paper (Dessaint et al. 2018), we provide evidence suggesting that this faulty informant channel plays a significant role. We analyse how firms’ investment decisions react to non-fundamental shocks to the stock prices of their peers (firms with correlated fundamentals). We posit that if managers have imperfect information about the payoffs of their investment projects, they should learn from all signals providing information about these payoffs, including the stock prices of firms with correlated fundamentals (see Foucault and Frésard 2014 for evidence). Thus, in sharp contrast to the agency or financing channels in which peers’ equity valuation are irrelevant, the faulty informant channel implies that a firm’s investment might be sensitive to the noise in other firms’ stock prices.
We find evidence supporting this hypothesis using a large panel of US public firms from 1996 to 2011. As a proxy for non-fundamental shocks to the stock price of the peers of a given firm, we use drops in peers’ stock price due to large capital outflows (redemptions) from mutual funds holding peers’ stocks in their portfolios. Indeed, such outflows force mutual funds to sell stocks at fire sale prices, i.e., far below the fundamental value of these stocks (see Coval and Stafford 2007 and Edmans et al. 2012). As predicted by the faulty informant channel, we find that firms in our sample reduce their investment significantly when the stock prices of their peers experience large drops due to mutual funds’ fire sales. Indeed, a one standard deviation increase in the non-fundamental component of peers’ stock price induces firms to cut their investment by 1.5% (4.3% of the average investment level in our sample), after controlling for the effects of their own stock price on investment and other variables known to affect investment (e.g., firms’ cash flows).
We estimate the resulting aggregate loss in investment to be about $29 billion per year between 1996 and 2011. According to the faulty informant hypothesis, this loss generates an opportunity cost for shareholders. Indeed, it corresponds to investments that were postponed (or cancelled) due to managers’ inferences from signals, which – with the benefit of hindsight – proved to be uninformative about fundamentals. According to our estimates, this opportunity cost ranges between $0.9 and $3.7 billion per year, depending on assumptions on the average net present value of new projects for the firms in our sample and discount rates.
It is difficult to explain these findings with the financing or agency channels. Indeed, these channels do not predict that non-fundamental variations in the stock price of a firm’s peers should influence its investment, after controlling for its own stock price. In addition, we find that the capital allocation across the different divisions of conglomerate firms is also affected by non-fundamental shocks to division peers’ stock prices. That is, non-fundamental shocks to the peers’ stock price of a particular division leads to a reallocation of capital away from this division, holding constant the investment of the entire firm. This observation is consistent with the faulty informant channel and cannot be explained by the other channels through which noise in peers’ stock price affects investment.
Overall, these results suggest that stock market inefficiencies matter for the real economy, even in the absence of financing frictions or agency problems. This new finding considerably broadens the type of firms affected by the noise in stock prices. In particular, this noise should affect not only financially constrained public firms or public firms facing agency problems but also cash-rich firms with well-incentivised managers, whether public or private (since managers of private firms can use the stock price of their publicly listed peers as signals).
Jensen (2005) suggests that one way to mitigate distortions in corporate investment due to noise in stock prices is to improve governance systems. When noise affects corporate investment by sending misleading signals to managers, this approach is insufficient. One also needs to improve managers’ ability and incentives to filter out the noise from the signal in stock prices.
Black, F (1986), “Noise”, Journal of Finance 41: 529-543.
Bond, P, A Edmans and I Goldstein (2012), “The real effects of financial markets”, Annual Review of Financial Economics 4: 339-360.
Coval, J and E Stafford (2007), “Asset fire sales (and purchases) in equity markets”, Journal of Financial Economics 86: 479-512.
Dessaint, O, T Foucault, L Frésard and A Matray (2019), “Noisy stock prices and corporate investment”, forthcoming, Review of Financial Studies.
Edmans, A, I Goldstein and W Jiang (2012), “The real effects of financial markets: The impact of prices on takeovers”, Journal of Finance 67: 933-971.
Foucault, T and L Fresard (2014), “Learning from peers' stock prices and corporate investment”, Journal of Financial Economics 111: 554-577.
Jensen (2005), “Agency costs of overvalued equity”, Financial Management 35: 5-19.
Morck, R, A Shleifer and R W Vishny (1990), “The stock market and investment: Is the market a sideshow?”, Brookings Papers on Economic Activity 2: 157-215.
 See “Green really is the new black as big oil gets a taste for renewables”, Guardian, 21 May 2016.