When Wall Street watches Washington: The link between equity prices, firm news, and economic policy uncertainty

A vast amount of literature shows that investors tend to under react to corporate events, such as earnings and profitability announcements. In this paper, we investigate how economic policy uncertainty, or the lack of a clear future economic policy path of the government, influences asset pricing and the reaction to firm-specific news. Thereby we bring together the two different streams of literature on investor attention and economic policy uncertainty. Specifically, we measure how economic policy uncertainty affects investors’ attention for firm-specific news and how it interacts with the market reaction to earnings news. To assess the interaction between firm news and economic policy uncertainty, we identify periods when increases in economic policy uncertainty compete for the attention of investors. We proxy economic policy uncertainty by the index constructed by Baker, Bloom and Davis (2016), who construct an index by quantifying the volume of newspaper articles dealing with policy-related economic uncertainty. To measure the stock price reaction following earnings news, we use the analyst data from I/B/E/S, which records forecasts of earnings on an analyst by analyst basis. Based on this, we identify whether the earnings announcement implied a positive or a negative surprise and its size. Based on different multivariate regression analyses, we find a complementary relationship between news about the government’s economic policy and firm news. When economic policy uncertainty is high, we find a stronger direct reaction to earnings news and a smaller post-earnings announcement drift. We find a comparable impact on trading volume, which reacts more strongly to earnings news on days with a relatively high level of economic policy uncertainty. Hence, high levels of economic policy uncertainty seem to keep investors more attentive and draw attention to the stock market. Consequently, investors pay more attention to firm news on days with concurrent news about the stance of economic policy.