Working Paper: CEPR ID: DP12657
Authors: Alexander F. Wagner; Richard Zeckhauser; Alexandre Ziegler
Abstract: How do market prices adjust towards their equilibrium values? Donald Trump’s election, an aggregate surprise that shook up the prices of all stocks, provides an ideal setting to investigate this question. Indeed, the ratio of price spreads among stock returns relative to aggregate market volatility on the first post-election day was one of the greatest seen in this century. Markets assessed the correct direction of relative price moves by individual stocks impressively quickly. The vast majority of stocks moved in the appropriate direction on the first day. However, given the extreme shock, iterations were required to get relative prices to converge to the right levels. To illustrate, return continuation from day 1 to day 2 was extreme by historical standards. Momentum persisted for three days and was followed by a brief reversal before prices settled. Since little new information was released after the election – a fact that we confirm by analyzing both transition team announcements and news flows – these return patterns represented movement toward a new equilibrium, and not a moving equilibrium. Stock return predictability was primarily driven by the part of first-day returns explained by firm characteristics, such as corporate taxes and foreign revenues, not by residual returns. The returns associated with a range of firm characteristics persisted for several days. Our results support prominent theories of slow but predictable diffusion of information into stock prices.
Keywords: stock returns; momentum; reversal; election surprise; market efficiency; predictability; price contribution analysis; corporate taxes; trade policy; event study
JEL Codes: G12; G14; H25; O24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Donald Trump's election (K16) | rapid adjustment in stock prices (G17) |
| rapid adjustment in stock prices (G17) | price spread ratio spiked on the first post-election day (E32) |
| initial shock from election outcome (K16) | observed price movements (E30) |
| firm characteristics (corporate taxes, foreign revenues) (F23) | predictability of stock returns (G17) |
| price adjustments (L11) | return continuation observed from day 1 to day 2 (C41) |
| momentum persisted for three days (C41) | brief reversal occurred (E32) |
| lack of significant new information (D83) | observed return patterns reflect movement toward new equilibrium (D53) |