Identifying the Role of Risk Shocks in the Business Cycle Using Stock Price Data

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I. INTRODUCTION

The finance literature on the forecastibility of stock returns has concluded that stock market movements are, by and large, not because of changes in the expected future cash flow of firms, but are primarily because of changes in the risk premium, that is, how the expected cash flows are discounted by stock market participants (Cochrane 2011). (1) These changes in risk premia also have important implications for real variables in the economy, especially for consumption and investment. An increase in the risk premium prompts households to reduce current consumption as they start to discount expected future income more heavily. More importantly, changes in the required return on equity alter the cost of capital of corporations when they finance new investment. For firms that rely on external debt to finance marginal investment, a lower stock price translates into lower net worth and therefore a higher cost of borrowing (Bernanke, Gertler, and Gilchrist 1999). Similarly, firms that rely on new equity issues are able to raise less funds from each new share when their stock price is lower. Even for firms that finance investment exclusively through internal funds (i.e., retained earnings plus depreciation allowance), the required return on existing shares reveals the opportunity cost of internally financed investment (Tobin 1969; Tobin and Brainard 1977). This is because, at least in principle, these funds can be returned to existing shareholders as dividends and new funds can then be raised from the markets through new equity shares for which investors would demand a risk premium.

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In the aggregate, U.S. corporations are predominantly financed through equity. The dotted line in Figure 1 plots the credit market liabilities of U.S. non-financial corporations as a percent of the sum of equity and credit market liabilities in their balance sheets. (2) By this measure, debt-financing accounts for about a third of total financing averaged over the whole sample, and equity-financing accounts for about two-thirds. The solid line in Figure 1 provides an alternative measure which takes into account all financial liabilities (including items such as trade payables), but nets out financial assets, to obtain a measure of net debt (McGrattan and Prescott 2005). Now, debt-financing accounts for only 15% of total financing in the post-war period, and its importance has declined in the last two decades. Note that both of these series are stock measures as opposed to flow measures; that is, they refer to financing of all past investments and do not necessarily reflect how corporations are financing investment at the margin. These measures can also be biased against debt-financing because most debt items are recorded on a book-value basis in the Flow of Funds, but equity is recorded on a market value basis.

To overcome these caveats, I consider the flow components of sources of funds (i.e., internal funds, net new equity, and net new debt) as a share of corporate tangible investment in Figure 2. Several patterns emerge: First, the ratio of internal funds to gross capital expenditures has been close to 1 throughout the post-war period. In other words, at least in the aggregate, U.S. corporate investment has been, by and large, financed internally. Second, new equity issuance has not been an important source of financing; in fact, net new stock issues have been mostly negative in the latter part of the sample. This mainly reflects the preference of corporations to distribute resources to shareholders through stock buybacks rather than ordinary dividend payments, because of the preferential tax treatment of long-term capital gains. Third, net new debt has contributed to about a third of aggregate financing, assuming that the discrepancy in the flow account is distributed proportionally to each financing component. As internal funds and net new stock issues are fairly reliable data series, we can reasonably lump the (rather large) discrepancy item in the FFA data with net debt. …

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