How Does the Stock Market Absorb Shocks?

47 Pages Posted: 30 Aug 2015 Last revised: 1 Apr 2018

See all articles by Murray Z. Frank

Murray Z. Frank

University of Minnesota

Ali Sanati

American University

Date Written: March 23, 2018

Abstract

Using a comprehensive set of news stories, we find a stark difference in market responses to positive and negative price shocks accompanied by new information. When there is a news story about a firm, positive price shocks are followed by reversal, while negative ones result in drift. This is interpreted as the stock market overreaction to good news and underreaction to bad news. These seemingly contradictory results can be explained in a single framework, considering the interaction of retail investors with attention bias, and arbitrageurs with short-run capital constraints. Consistent with this hypothesis, we find that both patterns are stronger when the attention bias is stronger, and when the arbitrage capital is scarce.

Keywords: stock return predictability, news, limits to arbitrage, limited attention, overreaction, underreaction, text analysis

JEL Classification: G12, G14

Suggested Citation

Frank, Murray Z. and Sanati, Ali, How Does the Stock Market Absorb Shocks? (March 23, 2018). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2652911 or http://dx.doi.org/10.2139/ssrn.2652911

Murray Z. Frank (Contact Author)

University of Minnesota ( email )

Carlson School of Management
321 19th Avenue South
Minneapolis, MN 55455
United States
612-625-5678 (Phone)

Ali Sanati

American University ( email )

4400 Massachusetts Avenue NW
Washington, DC 20816-8044
United States

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