How Does the Stock Market Absorb Shocks?

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