Bubbles, Fundamentals, and Investment: A New Multiple Equation Specification Testing Strategy

Dramatic fluctuations in the stock market raise questions about whether actual prices correspond to fundamentals. Even if there are "bubbles", they may not distort real behaviour if managers base investment decisions on fundamentals. Using a new specification testing strategy based on combining Q and Euler equations, we find that managers base investment decisions on fundamentals despite stock market bubbles. Three types of collateral evidence reinforce this interpretation. We would like to acknowledge useful comments from M. Galleotti, J. Huizinga, F. Schiantarelli, and J. Wilson, seminar participants at Carleton University, and the computational support provided by J.R. Dempsey. We would like to thank O. Blanchard and C. Rhee for letting us use their data; C. Rhee deserves special mention for explaining the construction of their data and providing us with related data not used in their paper. Any errors are our own.