How the stock market affects corporate decision-making

By Guest |  27-04-17 | 
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The stock market is seen as a reflection of what happens in the real world: A company releases poor earnings results and its stock price tanks, or shares rise if the firm becomes an acquisition target.

But Wharton research shows that how the stock reacts in turn affects a company's decision-making in a sort of feedback loop. And when corporate decisions are informed by the market, it leads to a higher market value for the firm.

Wharton finance professor Itay Goldstein talks with Knowledge@Wharton about this less-studied phenomenon that is encapsulated in his research paper, “The Incentives for Information Production in Markets Where Prices Affect Real Investment.”

This post initially appeared on the website of Knowledge@Wharton. It was republished on the websites of Morningstar U.S. and Morningstar Sydney. Below is an excerpt.

Tell us about your paper.

Let me start by taking a step back and connecting it to [a broader] research agenda, because this paper is really part of a group of papers that I have been working on in the last decade or so.

As the title of this paper suggests, what I'm interested in is financial markets that have an effect on the real side of the economy, that have an effect on real investment or other decisions on the real side of the economy.

And in order to understand why this research is needed, why it's important, I should note that the traditional paradigm in finance is to think about the financial market as a little bit like a sideshow. People study how prices form, how they reflect information, how asset prices are generated in equilibrium.

But usually, the financial market is there and is affected by the cash flows of the firm, by what the firm is doing. But there is no feedback effect. The financial market does not [seem to] affect what the firm will do.

What I have been trying to do in a series of papers--and this is the last one so far of this series--is to break this paradigm and think about a world where the financial market not only reflects what firms are doing, but also affects what firms are doing.

Because at the end of the day when you think about it, there are many traders in financial markets who spend a lot of time, energy, money, and effort in order to make a profit. They produce information. They trade on the information. Their information gets reflected in prices.

And it is only natural to believe that decision-makers in the real side of the economy--firm managers, creditors, regulators, directors, employees, customers, and so on--will take note then of what prices tell them, of the information in the price and then act according to the information in the price.

Here is a very practical example: Let's say that you're a CEO of a large company, and you just announced ... a new investment. [It may be] a merger or acquisition, an investment in a new plant or new product line. You announce that and the next day, your stock price decreases.

What are you going to do? Probably as a CEO who is tuned in to the market and realises that there is some information in the market that he can benefit from, you might reconsider the decision and maybe cancel [the investment].

This is the kind of channel that I'm looking into: how information in prices affects real decisions, and in turn, how these real decisions are also reflected in the information in prices, and so we really have a feedback loop where everything is co-determined.

What this paper [studies] is ... the incentive for information production when people know that their information is going to affect firm decisions as a result of cash flows and firm values.

Basically, what we show is that once one considers these decisions to produce information [that informs the stock price], then there is an amplification effect that makes shocks much larger in equilibrium.

Can you tell us more about your key takeaways?

First of all, what we note is that speculators in financial markets are more likely to produce information when they think that investments are going to be undertaken. Going back to my example before, let's say the CEO announced that they are considering an investment. Now speculators will have to start producing information and trade on the information.

Clearly for them, if they think that this investment is not going to be undertaken, there is no reason to produce information, because then the information becomes obsolete. So, they will be more likely to produce information when investments are actually likely to be undertaken, to be pursued through the final line. That is one effect that happens in our model.

The more interesting thing that happens as a result of that is there is an amplification effect of profitability on firm value. And this basically has two layers. One layer is the one that I just mentioned.

When investment opportunities are more likely to be undertaken, then there will be more information. So by and large, in good times, when investments are more likely to happen, there will be more information in financial markets.

The second layer is that information in financial markets increases the value of firms. Because when there is more information in financial markets, managers, directors, employees, and so on can make more informed decisions, which will increase the value of the firm.

Take these two layers together. One: In good times, there will be more information produced. Two: When there is more information produced, firms benefit from it. Essentially, what you get is this amplification effect.

As we move from bad times to good times, not only do we have the direct effect of just having a better time, but on top of it, as we move from bad times to good times, there will be more information that will assist us to even make better decisions, and our value will increase even more.

Can you give us some examples in the real world about this information in stock prices you're talking about?

Yes, absolutely. So, what kind of information could managers, for example, glean from the stock market? Let's say that a firm just announces that they want to acquire another firm. Once they do that, typically what speculators do is they start thinking, collecting information, and trading on information on whether they think this acquisition is a good idea.

There is past research that has shown that the information in the stock market is, indeed, indicative as to whether acquisitions are going to succeed or not. So, the market kind of figures it out. This is going back to the efficient market hypothesis.

People in the market collect information and figure out things, which can guide real decisions. So, the firm announces an acquisition, people in the market now start studying this acquisition, and they will trade based on whether they think it's a good idea or not.

Let's say people concluded the acquisition is not such a good idea. What will they do? They will start selling the stock. If they sell the stock, the price goes down. Now the manager looks at the stock price and he says, "I just announced an acquisition, and the price went down. Maybe the market doesn't think it's a good idea."

At this point, the manager will probably say, "I did my own analysis, and we ran our own simulations and projections and so on, but the market doesn't think it's a good idea. So maybe we should abandon it." That's the kind of information I have in mind.

The acquisition is really just one example. It can be anything else. It can be a firm that just announced they are going to open a new plant in another country. They do a press release that they're going to do this, and now the market reacts. If the market reacts negatively, they might reconsider their decision.

Were there any conclusions that surprised you when you were doing your research?

I would say that this amplification effect that I highlighted is really not something that I expected going into it, and I thought this was a very interesting result that comes out of the basics of financial analysis.

The idea that when fundamentals of the firm improve, there will be more information, and when there is more information, the firm will improve further--so any change in fundamentals will be amplified along this line.

What surprised me the most was the fact we found that this effect can be really quite large, and there can be a turning point, when all of a sudden information completely dries out of the market, and as a result the volume of investments will decrease dramatically, and the value of the firm will decrease dramatically.

So, the amplification, at certain points, can be quite significant. And maybe this is the thing that surprised me the most.

I should say that there is a lot of research in microeconomics and finance that is trying to understand amplification in financial markets. Because many people who observe financial markets and study them have this impression that things are amplified.

A small shock in fundamentals can lead to big consequences in terms of asset prices, firms' investments, and things like that. And there have been a few mechanisms that have been proposed and studied and tested along these lines.

What was interesting to me is that we can suggest a completely new mechanism that will generate this kind of amplification. And this new mechanism completely builds on the information that is coming from the financial markets.

So, once we believe that the financial market has some useful information for real investment decisions, then this amplification will naturally follow.

What are some practical implications of your findings?

In thinking about the practical implications, I [will consider] different audiences: traders in financial markets, firm managers, and regulators in government.

In thinking about traders, it's very important for them to take account of the fact that the way they trade and the resulting effects on prices do not end in the financial markets, but rather spill over to the real economy. Because when prices go down, people get more pessimistic, invest less, the real value of the firm could decrease, and as a result become a self-fulfilling belief.

So, big hedge fund managers and mutual fund managers and other big speculators should take note of the fact they also have an effect on what the firm will end up doing. It's not just that they are trading in order to make a profit.

In thinking about firm managers, they should be aware of the fact there is information in the price for them to learn from. And when they make a decision, they should take a look at the market reaction and see what the market is telling them. All of us are looking for feedback in all the things that we are doing, and firm managers are not different in that regard.

So, when they are contemplating a decision, there is a lot of useful information for them to take into account coming from the market. And understanding these theoretical results that we derive--it's really important to understand the nature of this information, how much you should rely on it, how reliable it is, and so on.

In thinking about regulators: Regulators are constantly worried about market volatility, the fact that asset prices are moving up and down, sometimes with no apparent reason, based on fundamentals. What they should focus on is not just the market itself, but the real effect of the market [as it] spills over to firms' decisions and to the real economy.

We describe it here, and I think the equilibrium mechanism that we describe is something that would be useful for them in understanding how important it is to control the stock market and how important it is to watch the consequences for the real economy.

We highlighted in a different paper that putting restrictions on short sales could make sense, because short sales could lead to some manipulation of stock prices that reduce real investment, and so there is some importance in putting restrictions on them, as regulators did in 2008.

This is an issue that is constantly being debated. So, I would say that for these three audiences, these are the practical implications that we have.

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