Stock Market Volatility and Investment: Do Only Fundamentals Matter?

The empirical evidence in the volatility literature suggests that movements in stock prices cannot be satisfactorily explained purely in terms of changes in fundamentals. This paper shows how to obtain proxies for the fundamental and fad components of changes in stock prices and asks the question: Do only fundamentals matter for investment decisions? We find that changes in investment are significantly associated with movements in both components of stock prices. The point estimates suggest that changes in fundamentals have a greater effect than changes in non-fundamentals. The statistical significance of the difference between their coefficients depends upon the financing regime. These conclusions are shown to be robust to modifications and extensions of the model.