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We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates a systematic risk factor, which we call “displacement risk.” This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.

We use price pressure resulting from purchases by mutual funds with large capital inflows to identify overvalued equity. This is a relatively exogenous overvaluation indicator as it is associated with who is buying – buyers with excess liquidity – rather than what is being purchased. We document substantial stock price impact associated with purchases by high-inflow mutual funds, and find the probability of an SEO, insider sales, and the probability of a stock-based acquisition increase significantly in the four quarters following the mutual fund buying pressure. These results provide new evidence that firm managers are able to identify and exploit overvalued equity. *Khan is at the Carlson School of Management, University of Minnesota. Kogan is at the MIT Sloan School of Management. Serafeim is at Harvard Business School. We thank Gordon Alexander, Jeff Callen, John Core, John DeTore, Campbell Harvey (Editor), Hai Lu, Krishna Palepu, Ricardo Reis, Jay Ritter, Sugata Roychowdhury, Ross Watts, Jeffrey Wurgler (AFA discussant), an anonymous referee and associate editor, and seminar participants at the Harvard Business School, London School of Economics, MIT, University of Minnesota, and the AFA Atlanta 2010 meetings for valuable comments.

In this review we survey the recent research on the fundamental determinants of stock returns. These studies explore how firms' systematic risk and their investment and production decisions are jointly determined in equilibrium. Models with production provide insights into several types of empirical patterns, including (a) the correlations between firms' economic characteristics and their risk premia, (b) the comovement of stock returns among firms with similar characteristics, and (c) the joint dynamics of asset returns and macroeconomic quantities. Moreover, by explicitly relating firms' stock returns and cash flows to fundamental shocks, models with production connect the analysis of financial markets with the research on the origins of macroeconomic fluctuations.