Do Arbitrageurs Amplify Economic Shocks?

We test the hypothesis that arbitrageurs amplify economic shocks in equity markets. The ability of speculators to hold short positions depends on asset values: shorts are often reduced following good news about a stock. Therefore, the prices of highly shorted stocks are excessively sensitive to shocks compared to stocks with little short interest. We confirm this hypothesis using several empirical strategies including two quasi-experiments. In particular, we establish that the price of highly shorted stocks overshoots after good earnings news due to short covering compared to other stocks