Financial Volatility, the Stock Market Crash and Corporate In vestment

STEPHEN BOND and MICHAEL DEVEREUX*

I . INTRODUCTION

There is little disagreement about the importance of investment. Investment by the corporate sector is a key determinant of both short-term fluctuations in demand and longer-term growth potential. It is therefore important to consider the implications of the stock market crash of October 1987: will corporate investment be lower than it would otherwise have been; and, if so, by how much? During October and November 1987, the FT-Actuaries All Share Index fell by almost 36 per cent, from a high of 1222 on 5 October to a low of 785 on 10 November. By late March 1988, there had been a partial recovery to around 910. This still represents a drop of about 20 per cent relative to the average index level for September 1987, the last month before the crash, and a fall of about 10 per cent compared with its level twelve months previously.

The effect of the stock market crash on business investment depends on the reasons underlying the crash, and in particular on the role played by purely speculative factors or ‘financial volatility’. There are conflicting views on the importance of financial volatility. At one extreme the mere possibility is denied. The stock market is maintained to be strongly efficient, in the sense that share valuations accurately reflect the present discounted value of (optimally) forecasted future dividends. On this view, held by a number of financial economists, the market crash signals a new era of lower expected profitability, and a niajor impact on investment would appear to be inevitable. But this view is not universal, and there are those who entertain

* Stephen Bond is a Research Officer and Michael Devereux is a Programme Director at the Institute for Fiscal Studies.

The authors would like to thank Manuel Arellano, Richard Blundell, Bill Robinson, Michael Saunders and Ian Walker for helpful comments, and 3i and Graham Bannock for providing the results of their survey of companies. The research reported in this paper was financially supported by the Economic and Social Research Council under project BOO232207 and by the Gatsby Foundation.

Financial Volarifii‘y, the Stock Market Crush and Corpora?e fn vestment

the idea that ‘fads’ or ‘speculative bubbles’ affect share prices. These speculative influences may be unrelated to prospects for real investment. In this case the stock market crash could simply signal the end of a previous fad or bubble, with a minimal impact on real investment. This was the position taken by Nigel Lawson in his Budget Speech, when he argued that the crash was ‘essentially an overdue market correction which did little more than reverse the rapid rise in share prices of the previous year’.

In this paper we briefly review the reasons why a fall in share prices might be associated with a reduction in corporate investment. We then present some new evidence which suggests that this effect is likely to be small. This finding is in agreement with the indications from the latest CBI Industrial Trends Surveys and is consistent with an important role for financial volatility.

11. LINKS BETWEEN SHARE PRICES AND INVESTMENT

There are perhaps three main routes by which a fall in a company’s share valuation may be reflected in lower investment. First, the fall may be associated with a decline in business confidence and expectations of future profitability. Causality could run either way. On the one hand, the stock market crash may have a direct impact on business confidence. Such an impact is difficult to quantify. Much depends on how industrialists themselves view share price fluctuations. It is certainly possible that the managers who actually take investment decisions consider that they have better information about their opportunities and prospects than do investors on the Stock Exchange. In this case the direct effect of share price movements on business confidence may be weak. On the other hand, the share price movements may themselves reflect changes in managers’ confidence. In this case the stock market crash might simply be the realisation by shareholders of a slump in the confidence of British industrialists.

Secondly, there may be an indirect influence on firms’ expectations of future demand resulting from the reduced value of shareholders’ wealth. The significance of wealth effects on consumption has received some support from recent econometric studies. What matters here is not the effect on the firm’s own shareholders but rather the effect on the firm’s customers. This influence on investment therefore depends more on the market as a whole than on the firm’s own share price, and is likely to be strongest when prices move together as in the recent crash. However, the importance of this effect also depends on whether the share price movements are perceived as being temporary or permanent. Thus if consumers were to discount what they perceived to be transitory movements reflecting financial volatility when considering the permanent value of their wealth, then the effect on consumption would be minimal.

Thirdly, there may be some effect from the increased cost of issuing new shares in order to finance investment. At a lower share price the firm must

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sell a larger number of shares in order to raise a given amount of finance. The issue therefore becomes larger relative to the firm's market capitalisation, and may be more difficult to place. Again, this effect may be strongest when all share prices have fallen and the market is weak. Firms may also be concerned about the implications for future dividend payments. If there are constraints on the ability of firms to reduce dividend payments per share - perhaps because this may be interpreted as an adverse signal by the market - then a greater number of shares outstanding implies a higher servicing cost in the future. However, there are two reasons for suspecting that the impact on investment of higher costs of issuing new shares will be small. First, the volume of investment that is actually financed by new share issues has generally been only a tiny fraction of total corporate investment in recent years. Mayer (1987) estimates that only 4 per cent of the total corporate capital stock in existence in 1984 had been financed by issuing new shares. In addition, there is certainly some scope for substituting other forms of investment finance, notably borrowing and retained earnings, even in cases where an equity issue had previously been planned.

There are therefore plausible reasons why each of these transmission mechanisms might be weak, particularly when share price movements are perceived to result from financial volatility. To say more, we must consider the empirical evidence. If these influences from share prices do exert a major effect on corporate investment, then it should be reflected in the correlation between past movements in the stock market and investment. Some impression is provided by Figure 1, in which we show measures of both the

FIGURE I Share Prices and the Rate of Investment

l 5 r

'-- Investment r , rate(%) /

1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986

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Financial Volatility, the Stock Market Crmh and Corporate lnvestment

rate of investment and the real level of the stock market. The former is the annual flow of gross fixed investment by industrial and commercial companies, as a proportion of their end-year net capital stock at replacement cost. The stock market indicator is simply the FT-30 index deflated by the retail price index, and expressed as an index with 1970= 10. The graph suggests some association between the stock market and investment, particularly over the last decade, but the evidence is mixed. For example, during the periods 1968-70 and 1972-74, falls of 30 per cent and 60 per cent in the real level of the FT index were not associated with unusual changes in investment, and in 1986 the market rose by 24 per cent in real terms whilst the rate of investment actually fell. Clearly, since other factors may influence investment, it is not surprising that the graph is inconclusive. In the next section we present the findings of a more detailed econometric study.

111. ECONOMETRIC EVIDENCE

The economic model of investment that is most helpful in assessing the impact of stock market movements is that which relates the rate of investment to Tobin’s Q, the ratio between the market’s valuation of capital within the firm and the current cost of acquiring that capital. This model was suggested by Tobin (1969) and has been developed by Summers (1981) and Hayashi (1982), amongst others. Recent research at IFS has examined the behaviour of company investment in the UK within this framework, and is directly relevant to the questions we address in this paper.

The basic idea of the Q model is that the firm will expand its capital stock when the market values capital in its hands above the going price of capital goods. This intuitive idea has recently been given a theoretical underpinning. Under certain conditions, it can be shown that the investment of a wealth- maximising firm will be positively associated with this ratio, suitably modified for the existence of taxes (see Hayashi (1982) or Blundell et al. (1987) for details).

We have estimated this relationship using data for a sample of 202 quoted UK companies whose main activity is within manufacturing, over the period 1975 to 1984. Our principal data source is company accounts information from Datastream International. For each company, we combine this with market valuation data obtained from the London Share Price Database.

The simplest model that we find to be supported by the data takes the form:

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Here I,-, denotes the total additions (net of disposals) to firm i’s capital stock during its accounting year t. Kit denotes the current replacement cost value of firm i ’s stock of fixed assets at the end of financial year t. We obtain these inflation-adjusted estimates of each company’s capital stock using the standard perpetual inventory approach. For this exercise we have followed King and Fullerton (1984) in assuming annual rates of depreciation in UK manufacturing of 8.2 per cent for plant and machinery and 2.5 per cent for land and buildings. In related work (Bond and Devereux (1988)), we have found that our parameter estimates are not highly sensitive to the particular estimates of the capital stock used.

In constructing our measure of Q, we account for the fact that companies have assets and liabilities other than fixed capital, and that these other assets will be reflected in stock market valuations. We therefore adjust the firm’s equity capitalisation by adding its stock of outstanding debt and subtracting the value of its inventories and liquid assets. We also deduct the present value of the tax depreciation allowances that the firm will be able to claim in the future on the strength of its existing capital stock. These future allowances are clearly an asset to the firm, and we estimate their value using the company-by-company model of corporation tax described in Devereux (1986). Finally our measure of Q makes allowance for the effects of corporation tax in reducing the effective price of capital goods to the firm - through capital allowances - and in reducing the effective price received by the firm for its output.

We measure Qit at the beginning of each company’s financial year, and so it is predetermined relative to our investment equation. Our estimates of the parameters 01, 0 and y are obtained by pooling the time-series and cross- section variation in the data. The presence of unobservable firm-specific influences on investment rates raises some technical issues which are discussed in Blundell et al. (1987). Essentially we find that Q is not significantly correlated with these firm-specific effects. In this case consistent estimates can be obtained using a generalised least squares procedure. We estimate:

(+)i, = 0.06375 + 0.01327Qe + 0.25365 ($);,,-, (0.00395) (0.00263) (0.03108)

where heteroscedasticity-consistent standard errors are reported in parentheses. There is no evidence of serial correlation in the residuals, and the model appears to be stable across shorter sub-samples of our data.

These estimates indicate that the short-run effect of share price movements on the corporate capital stock is very small relative to their long-run effect. In the long run, the Q model imposes a proportional relationship between market valuation and the capital stock. However, our results suggest that

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Finunciul Voluiiliiy, the Stock Murket Crush and Corporate Zn vesiment

adjustment to this long-run equilibrium is very slow, with a half-life of about thirty years.

We have used this model to simulate the effect of stock market movements on investment in the short run. We consider a once-and-for-all fall of 20 per cent in all share prices. The main difficulty that we face is in assessing the impact of a given change in the share price on the market’s valuation of the firm’s fixed capital, given that companies have assets and liabilities other than fixed capital. Our assumption is that the level of debt is unchanged and that the market’s valuation of other assets, such as stocks and liquid assets, is also unchanged. Based on our sample data, we then estimate that a 20 per cent drop in the share price corresponds to about a 16 per cent reduction in the stock market valuation of fixed capital.

TABLE 1

Simulated Effects of a Once-and-for-all 20% Fall in the Stock Market during 1987

Percentage change in the investment

rate’ relative to the ‘no crash’ case

Percentage change in the capital stock relative to the ‘no

crash’ case

1988 1989 1990

- 2.9 - 3.6 - 3.7

- 0.3 - 0.6 - 1.0

a The investment rate is defined as the level of investment as a proportion of the end-of-period replacement value of the capital stock. The effect on the level of investment is similar to that on the rate of investment.

In Table 1 we present the results of this simulation. These estimates may be interpreted as showing how investment after the crash will compare with what investment would have been had the stock market levels of September 1987 persisted. This is something of an extreme case, neglecting any impact of the pre-crash bull market on investment. We estimate that the rate of investment is about 3 per cent lower than it would otherwise have been in the first year after the crash, and around 3+ per cent lower in the second and third years. This may be compared with actual changes in the rate of investment in 1984, 1985 and 1986 of 9.3 per cent, 17.8 per cent and -3.9 per cent respectively (see Figure 1). This change is also small in relation to national income. As a percentage of GDP in 1986, for example, total gross domestic fixed capital formation by industrial, commercial and financial companies was only about 8.8 per cent. The first round effect of business investment being lower by 3 per cent would thus be a reduction in GDP of only one-quarter of one per cent.

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Fkcd Srudies

1V. OTHER EVIDENCE

Our econometric results therefore suggest that whilst there is a significant relationship between stock market valuations and corporate investment, the quantitative effect of share price movements on investment is small. In this section we report some independent evidence which points to very similar conclusions.

The CBI’s quarterly Industrial Trends Survey includes the following question: ‘Do you expect to authorise more or less capital expenditure in the next twelve months than you authorised in the past twelve months on: a) buildings; b) plant and machinery?’. The inquiry is carried out early in January, April, July and October of each year and covers approximately 1500 manufacturing firms. Firms are asked to respond in one of four categories - more, same, less or not applicable. In Figure 2 we show the difference between the percentage of firms replying ‘more’ and the percentage of firms replying ‘less’ to each question over the period October 1983 to January 1988. The figures are weighted by the CBI to take account of differences in firm size. Also shown in Figure 2 are the movements in the FT- Actuaries All Share Index over the same period. The average level of the index during the month preceding each survey is deflated by the retail price index, and expressed as an index with January 1984=25. Comparing the survey responses for January 1988 (post-crash) with those for October 1987 (pre-crash) suggests that the stock market crash has had a minimal impact on business investment intentions. In fact the January 1988 survey indicates a

FIGURE 2 Investment Intentions and the Crash:

Evidence from CBI Surveys 6 O r

40 501 301/

//- Real FT / index /

/-----/

/ .’ /---- \-. -

I \ \

/ /’

-.Jq I- \ /-

-10 .-

Buildings

I I I I I I I I I I I I I I I I I 1984 1985 1986 1987 1988

- 30

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Financial Vofatilify, the Sfock Marker Crash and Corpoafe In vesfmenf

slight increase in the number of firms expecting to authorise more investment.

More direct evidence on the links between share prices and investment is provided by a survey carried out for 3i by Graham Bannock and Partners Ltd. During March 1988 a sample of 205 companies in which 3i had recently invested were asked to give their views on the stock market crash. Some of the results are reproduced in Table 2. Of these firms, 63% attributed the stock market crash to the puncturing of a speculative boom. Less than a quarter suggested that the crash had affected their own confidence, and only 14% said that their plans for raising capital had been affected. This evidence is very much in line with our econometric results.

TABLE 2

Evidence from the 31 Enterprise Barometer

Percentage of replies

Which of the following statements most closely expresses your thoughts on the causes of the stock market crash?

The inevitable puncturing of a speculative boom A genuine deterioration in the world economic outlook A combination of these and other factors Do not know / Have no thoughts

62.9 3.9

30.7 2.4

Has the stock market crash affected any of the following?

Your own confidence in the short-term outlook 23.4 Your own confidence in the long-term outlook 11.2 The cost and availability of capital to your firm 13.2 Any plans you may have for raising capital by flotation, borrowing or other means 14.1

Note: Reproduced with permission from the new quarterly survey, 3i Enterprise Barometer. This survey is intended to monitor attitudes to enterprise and developments in the small and medium-sized growth companies in which 3i invests.

V. CONCLUSION

The answers to the questions that we posed at the start of this paper now seem to be clear. The stock market crash is likely to have some depressing effect on corporate investment, but this effect is not likely to be large. Our estimates suggest that investment in 1988 may be about 3 per cent lower than would have been the case if the share price levels of September 1987 had been sustained. A reduction of 3 per cent is small relative to recent fluctuations in

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Fiscul Studies

the rate of investment. We have also noted that even this estimate exaggerates the effect on investment in 1988 of stock market movements during the whole of 1987. Survey evidence reinforces the view that the crash will have a limited impact on corporate investment.

We have suggested that this conclusion is consistent with the hypothesis that volatile speculative factors play an important role in financial markets. Of course we have provided only indirect evidence on this issue. There is now a substantial body of more direct evidence suggesting the importance of ‘excess volatility’, ‘myopia’ or other inefficiencies in stock market prices (see, amongst others, Shiller (1981), Nickell and Wadhwani (1987), Poterba and Summers (1988) and West (1988)). Whilst financial volatility may not be the only explanation of our results, we certainly find them difficult to reconcile with the view that the stock market is strongly efficient. On the contrary, they may indicate that only a small fraction of share price movements contain information that is relevant for real investment.

REFERENCES

Blundell, R. W., Bond, S. R., Devereux, M. P. and Schiantarelli, F. (1987), ‘Does Q matter for investment? Some evidence from a panel of UK companies’, IFS Working Paper no. 87/ 12.

Bond, S. R. and Devereux, M. P. (1988). ‘Testing the sensitivity of Q investment equations to measurement of the capital stock’, in M. Funke (ed.), Factors in Business Investment, Springer, forthcoming.

Devereux, M. P. (1986), ‘The IFS model of the UK corporation tax’, IFS Working Paper no. 84.

Hayashi, F. (1982). ‘Tobin’s average q and marginal q: a neoclassical interpretation’, Econometrica, vol. 50, pp. 215-224.

King, M. A. and Fullerton, D. (1984), The Taxation of Income from Capital: A Comparative Study of the United States, the United Kingdom, Sweden and West Germany, Chicago and London: University of Chicago Press.

Mayer, C. P. (1987). ‘New issues in corporate finance’, Centre for Economic Policy Research Discussion Paper no. 181.

Nickell, S. and Wadhwani S. (1987), ‘Myopia, the dividend puzzle and share prices’, Centre for Economic Policy Research Discussion Paper no. 155.

Poterba, J. M. and Summers, L. H. (1988), ‘Mean reversion in stock returns: evidence and implications’, London School of Economics Financial Markets Group Discussion Paper no. 5 .

Shiller, R. J. (1981), ‘DO stock prices move too much to be justified by subsequent changes in dividends?’, American Economic Review, vol. 71, pp. 421-436.

Summers, L. H. (1981), ‘Inflation, taxation and corporate investment: a Q theory approach’, Brookings Papers on Economic Activity, vol. I , pp. 67-140.

Tobin, J. (1969). ‘A general equilibrium approach to monetary theory’, Journal of Money, Credit and Banking, vol. 1, pp. 15-29.

West, K. D. (1988). ‘Dividend innovations and stock price volatility’, Econometrica, vol. 56, pp. 37-62.

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