Wharton’s Itay Goldstein discusses the feedback loop between the stock market and corporate decision-making.

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 this is not the end of the road for the stock market’s impact; 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.

Stock Market
3112014 / Pixabay
Stock Market

Wharton finance professor Itay Goldstein talks with [email protected] about this less-studied phenomenon that is encapsulated in his research paper, “The Incentives for Information Production in Markets Where Prices Affect Real Investment.” (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

[email protected]: Tell us about your paper.

Itay Goldstein: 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 realizes 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.

“Think about a world where the financial market not only reflects what firms are doing, but also affects what firms are doing.”

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.

[email protected]: Can you tell us more about your key takeaways? I think you started alluding to them in your answer.

Goldstein: 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 that 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.

[email protected]: Can you give us some examples in the real world about this information in stock prices you’re talking about?

Goldstein: 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

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