Equity Finance: Financing Innovation and Long-Term Household Wealth

Equity markets function to raise capital, allocate capital, and distribute the gains to investors and households. Yet few economic courses cover these markets even while many students are fascinated by the workings of these equity markets. The positive capital allocation function is sometimes overshadowed by speculation. The speculation aspect is certainly there but the existence of cognitive biases, such as the recency bias, help define the behavioral problems in equity pricing. As is true of pricing and credit cycles, expectations may not match real outcomes thereby providing a dynamic impulse to equity investing. The earnings/price ratio is not mean reverting and yet investors often benchmark their sense of value against an average earnings/price ratio measured over an arbitrary period. Instead, equity valuations, relative to nominal GDP, have a more volatile pattern that reflects the influence of other economic price, such as interest rates.