Asset Prices and Real Investment

Firm investment activity and firm characteristics, particularly the market-to-book ratio or q, are functions of the state of the economy and therefore contain information about the dynamic behavior of stock returns. This paper develops a model of a produc-tion economy in which real investment is irreversible and subject to convex adjustment costs. During low-q (high-q) periods when the irreversibility constraint (constraint on the rate of investment) is binding, conditional volatility and expected returns on one hand, and market-to-book ratios on the other, should be negatively (positively) related. Empirical tests based on industry portfolios support these predictions for conditional volatility but not for expected returns