Inventory and the Stock Market

An extended abstract of a 2005 winner of the MSOM Society Student Paper Competition. My study is motivated by the growing body of evidence that the stock market is not efficient. In the inefficient-markets view, the stock market can temporarily over- or undervalue firms, even if this misevaluation works itself out of stock prices over time. In this paper, I empirically test the inefficient markets view. First, I test whether the stock market's ‘behavioral’ component (if it exists) affects inventory. Second, I test how this happens. To investigate the first, I test a null fundamentals only hypothesis, that the stock market has no impact on firms' inventory levels other than through fundamentals. To investigate the second, I consider three channels through which inefficient markets might affect inventory. One possibility is a financing channel. For financially constrained firms, overvaluation allows them to raise financing and increase inventory to optimal levels. Another possibility is a dissipation channel, based on the idea of shirking in principal–agent models. When the market misvalues firms, firms become less disciplined and let inventories rise. The third is a catering channel. When the market discounts high-inventory firms, firms decrease their inventory. When the market places a premium on inventory, firms increase their inventory.