The Reaction of Stock Returns to News about Fundamentals
Forthcoming, Management Science
38 Pages Posted: 21 Mar 2007 Last revised: 19 Feb 2014
Date Written: November 15, 2005
In good times, stock prices react negatively to good news and positively to bad news, while in bad times, they react positively to good news and negatively to bad news. To account for this stylized fact, we consider an asset pricing model where the dividend growth rate switches between different values depending on the underlying state of the economy. Investors never observe the true dividend growth rate but learn about it through not only its realizations but also external signals such as macroeconomic indicators. Under plausible assumptions, the differing precision of external signals across different states of the economy can change the sign of the market reaction to news from external signals in good and bad times.
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