Disentangling Investment Returns and Stock Returns: The Importance of Time-to-Build

Abstract

I provide new evidence on the failure of the Q-theory. The Q-theory implies the state-by-state equivalence of stock and investment returns|a important implication of many asset pricing models. Using aggregate US data, I nd there exists a realistic pa- rameterization of the aggregate production and adjustment cost function such that em- pirical investment returns have rst and second moments similar to historical US stock returns. Investment and stock returns are negatively correlated, however, contradicting the Q-theory. This paper also proposes a rational explanation for this nding. A general equilibrium model with production, in which investment projects involve time-to-build, can rationalize these ndings. The model is also able to explain the negative correlation of investment growth and stock returns at the aggregate level|an observation that has been interpreted as evidence for irrational markets since it cannot be reconciled with the Q-theory of investment.