It is well known that firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low. We document that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the trade-off between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and cross-sectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar-* Department of Economics, Harvard University, Cambridge, Massachusetts

We present a model of mergers and acquisitions based on stock market misvaluations of the combining firms. The model explains who acquirers whom, whether the medium of payment is cash or stock, what the valuation consequences of mergers are, and why there are merger waves. Some of the key predictions of the model are: 1) acquisitions are disproportionately for stock when market valuations are high, and for cash when they are low; 2) targets in cash acquisitions earn low returns prior to the acquisitions, whereas bidders in stock acquisitions earn high returns; 3) long run returns to bidders in stock acquisitions are likely to be negative, those to bidders in cash acquisitions are likely to be positive; 4) despite negative long run returns, acquisitions for stock serve the interest of long run shareholders of the bidder; 5) diversification strategies serve the interest of bidding shareholders even when they earn negative announcement returns; 6) such diversifying acquisitions are likely to be for stock; 7) management resistance to cash tender offers is often in the interest of shareholders; 8) acquisition targets are likely to have managers and shareholders with relatively shorter horizons than the bidders. 1 We are grateful to Robin Greenwood and Rafael La Porta for helpful comments, to Mark

We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective is threefold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena.

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We use a simple model to outline the conditions under which corporate investment is sensitive to non-fundamental movements in stock prices. The key prediction is that stock prices have a stronger impact on the investment of “equity dependent ” firms – firms that need external equity to finance marginal investments. Using an index of equity dependence based on the work of Kaplan and Zingales [1997], we find support for this hypothesis. In particular, firms that rank in the top quintile of the KZ index have investment that is almost three times as sensitive to stock prices as firms in the bottom quintile.

Given the historically high equity premium, is it now a good time to invest in the stock market? Economists have suggested a whole range of variables that investors could or should use to predict: dividend price ratios, dividend yields, earnings-price ratios, dividend payout ratios, net issuing ratios, book-market ratios, interest rates (in various guises), and consumptionbased macroeconomic ratios (cay). The typical paper reports that the variable predicted well in an in-sample regression, implying forecasting ability. Our paper explores the out-of-sample performance of these variables, and finds that not a single one would have helped a real-world investor outpredicting the then-prevailing historical equity premium mean. Most would have outright hurt. Therefore, we find that, for all practical purposes, the equity premium has not been predictable, and any belief about whether the stock market is now too high or too low has to be based on theoretical prior, not on the empirically variables we have explored.

When the discount rate falls, investment should rise. Thus with time-varying discount rates and instantly changing investment, investment should positively covary with current stock returns and negatively covary with future stock returns. Aggregate nonresidential U.S. investment contradicts both these implications, probably because of investment lags. Investment plans, however, satisfy both implications. These investment plans, from a U.S. government survey of firms, are highly informative measures of expected investment and explain more than threequarters of the variation in real annual aggregate investment growth. Plans have substantial forecasting power for excess stock returns, showing that time-varying risk premia affect investment. A BASIC IDEA IN ECONOMICS and finance is that when the discount rate falls, investment should rise. If discount rates move over time and investment instantly adjusts, then the idea has two implications. First, investment and stock returns should positively covary over time. This positive contemporaneous

We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test this prediction by studying how the cross-section of subsequent stock returns varies with proxies for beginning-of-period investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, consistent with an initial underpricing of these stocks. When sentiment is high, on the other hand, these patterns attenuate or fully reverse. The results are consistent with predictions and appear unlikely to reflect an alternative explanation based on compensation for systematic risk.

We develop a theory in which the decision to pay dividends is driven by investor demand. Managers cater to investors by paying dividends when investors put a stock price premium on payers and not paying when investors prefer nonpayers. To test this prediction, we construct four time series measures of the investor demand for dividend payers. By each measure, nonpayers initiate dividends when demand for payers is high. By some measures, payers omit dividends when demand is low. Further analysis confirms that the results are better explained by the catering theory than other theories of dividends.