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New Research Reveals Corporate Investment Misperceptions

New Research Reveals Corporate Investment MisperceptionsNew Research Reveals Corporate Investment MisperceptionsSimon Business School

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The effects of the 2008 Global Financial Crisis are still rippling through the economy leaving open questions about how corporate investment is affected by changes in market uncertainty and interest rates. Contrary to widely held assumptions, investment growth has little to do with changes in market volatility or interest rates. In fact, according to new research from Simon Business School, the investment decline following the financial crisis was not unusual given the drop in gross domestic product (GDP) and corporate profits at the end of 2008.

The findings from the study, The Behavior of Aggregate Corporate Investment,” cast doubt on Federal Reserve policies which claim that reducing interest rates will fuel more investment and thereby lift all economic boats. This research draws conclusions which challenge both conventional wisdom and formal theoretical models.

“We found little evidence that unusual conditions in credit markets lead to a large drop in investment over and above what would be expected given changes in the real economy,” said Jerold Warner, a professor of finance and business administration from Simon Business School and a co-author of the study. “This lack of a link between aggregate investment and interest rates is particularly interesting and shines a light on important macroeconomic and policy implications.”

The research highlights three main findings:

  • Investments grow rapidly following high profits and stock returns, but on the margin, has almost no connection to interest rates or market volatility.
  • Investments correlate negatively with future profits and market returns, the latter effect concentrated in the one or two quarters after investment.
  • There is little evidence that unusual conditions in the credit markets led to a large drop in investment over and above what would be expected given changes in the real economy.

Warner and his co-authors S.P. Kothari of the Massachusetts Institute of Technology and Jonathan Lewellen of the Tuck School of Business at Dartmouth College, demonstrate that investment grows rapidly following high profits and stock returns. They also expose that when aggregate corporate investment goes up, future profits and market returns go down. This particular connection is so strong that it almost fully reverses the profit growth leading up to investment.

The researchers studied aggregate corporate investment by U.S. firms from 1952 to 2010. Using quarterly financial information from public companies they looked at the total amount of capital investment by all firms under a variety of economic conditions. They concluded that reducing interest rates does not always influence corporate capital investment.

Problems with credit markets may have played a role in the Financial Crisis of 2008, but the impact on corporate investment is arguably small relative to a decline in investment opportunities following the recession. This study also shows that the behavior of aggregate investment has important macroeconomic and policy implications, which can assist policymakers to better understand how firms make investment decisions. 

To learn more about the cutting-edge research being conducted at Simon Business School, please visit www.simon.rochester.edu.

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