Speculation, Overpricing, and Investment - Theory and Empirical Evidence

In this paper I investigate whether firms’ physical investments react to the speculative over-pricing of their securities. I introduce investment considerations in an infinite horizon continuous time model with short sale constraints and heterogeneous beliefs along the lines of Scheinkman and Xiong (2003). I obtain closed form solutions for all quantities involved. I show that market based q and investment are increased, even though such investment is not warranted on the basis of long run value maximization. Moreover, I show that investment amplifies the effects of speculation on prices through an increase in the value of "growth" options. In the empirical section of the paper, I use a simple episode to test the hypothesis that investment reacts to over-pricing. With publicly available data on short sales during the 1920’s, I examine both the price reaction and the investment behavior of a number of companies that were introduced into the "loan crowd" during the first half of 1926. In line with Jones and Lamont (2002), I interpret this as evidence of overpricing due to speculation. I find that investment by these companies follows both the increase and the decline in "q" before and after the introduction, suggesting that companies in this sample reacted to security over-pricing. JEL Codes: E2, G1, G3, N2