Abstract
If a lack of trust causes investors to discount the information in accounting numbers, then the stock price will tend to under-react to earnings surprises. Using survey measures of interpersonal trust across regions of the United States, we find greater stock price reactions to earnings surprises for firms located in high trust regions. Their counterparts located in low trust regions experience sluggish reactions to earnings news, but subsequently experience greater price drift. Our results are not due to firm characteristics, respondent attributes, or regional differences in economic and social conditions, and are robust to the inclusion of state and firm fixed effects. The impact of trust is mitigated through signaling (i.e., dividend payout and debt) and external certification (i.e., credit rating and auditor choice). Following the passage of the Sarbanes-Oxley Act, the relation between trust and stock price reactions to earnings surprises is eliminated, highlighting the interconnection between regulation, trust, and market efficiency.
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