Political Sentiment and Predictable Returns

Abstract

This study shows that shifts in political climate influence stock prices. As the party in power changes, there are systematic changes in the industry-level composition of investor portfolios, which weaken arbitrage forces and generate predictable patterns in industry returns. A trading strategy that attempts to exploit demand-based return predictability generates an annualized risk-adjusted performance of six percent during the 1939 to 2011 period. This evidence of predictability spans 17-27% of the market and is stronger during periods of greater political awareness. Our demand-based predictability pattern is distinct from cash-flow based predictability identified in the recent literature.

Underreaction to Political Information and Price Momentum

“…To identify firms and industries that are politically favored, we construct a measure of political sensitivity at the stock and industry levels using the method proposed in Addoum and Kumar (). The estimation process is summarized for industry portfolios.…”

“…Although the political environment depends on factors beyond the presidential party (e.g., the president's approval rating, congressional control, and lobbying activities), our simple approach is motivated by past studies of politics and the macroeconomy. In particular, Santa‐Clara and Valkanov () and Addoum and Kumar () find that congressional control has little impact on the effects associated with the president's partisan ties. Furthermore, our market‐based measure of political sensitivity is available for a long sample period and provides evidence that investors underreact to even highly salient information captured by the presidential party.…”

“…The political climate is also an important determinant of investors’ portfolio decisions. For example, Bonaparte, Kumar, and Page () and Addoum and Kumar () show that investors adjust their portfolios following changes in the political environment. In particular, Addoum and Kumar () demonstrate that retail and institutional investors gradually tilt their portfolios toward stocks in politically favored industries when there is a change in the presidential party.…”

“…For example, Bonaparte, Kumar, and Page () and Addoum and Kumar () show that investors adjust their portfolios following changes in the political environment. In particular, Addoum and Kumar () demonstrate that retail and institutional investors gradually tilt their portfolios toward stocks in politically favored industries when there is a change in the presidential party. Although they show that these portfolio reallocations in turn generate short‐term predictability in stock and industry returns, Addoum and Kumar () do not examine the impact of shifts in the political environment on momentum profits.…”

“…Specifically, we construct a long ‐ short portfolio based on political sensitivity estimates of firms and industries. We measure political sensitivity using the Addoum and Kumar () method and classify momentum winner and loser portfolios into politically consistent (i.e., favored) and politically inconsistent (i.e., unfavored) categories.…”