The Reaction of Stock Returns to News about Fundamentals

Abstract

This paper analyzes the reaction of stock returns to news about the state of the economy. We develop a general equilibrium asset pricing model where the investor learns about the growth rate of the economy through two sources of information, dividend realizations and regularly scheduled announcements about the state of the economy. We distinguish between dividend news and the unexpected part of the external signal and characterize the reaction of stock returns to news from these two sources of information. We show that the reaction to these news variables can be quite different under different assumptions about their precisions in different states. Our model is able to account for several empirical facts about the reaction of stock returns to news, such as time-varying and state-dependent reaction, asymmetric reaction to extreme news and stronger reaction to more precise signals.