The Presidential Puzzle: Political Cycles and the Stock Market

The excess return in the stock market is higher under Democratic than Republican presidencies: 9 percent for the value‐weighted and 16 percent for the equal‐weighted portfolio. The difference comes from higher real stock returns and lower real interest rates, is statistically significant, and is robust in subsamples. The difference in returns is not explained by business‐cycle variables related to expected returns, and is not concentrated around election dates. There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium. The difference in returns through the political cycle is therefore a puzzle.     

Is the presidential premium spurious?

A hotly debated question in finance is whether the higher stock returns under Democratic presidencies relative to Republican presidencies represent abnormal return, risk premium, or mere statistical fluke. This paper investigates whether this presidential premium is due to spurious-regression bias, data mining, or economic policy uncertainty. Decomposing the presidential premium into expected and unexpected components, we find that over two-thirds of the premium is unexpected, which is inconsistent with the spurious regression bias explanation. The presidential premium is not explained by data mining given that it persists in the post-publication period, and remains robust even if we purge returns of their covariation with economic policy uncertainty.     

Government spending,political cycles,and the cross section of stock returns

Using a novel measure of industry exposure to government spending, we show predictable variation in cash flows and stock returns over political cycles. During Democratic presidencies, firms with high government exposure experience higher cash flows and stock returns, while the opposite pattern holds true during Republican presidencies. Business cycles, firm characteristics, and standard risk factors do not account for the pattern in returns across presidencies. An investment strategy that exploits the presidential cycle predictability generates abnormal returns as large as 6.9% per annum. Our results suggest market underreaction to predictable variation in the effect of government spending policies.     

Political Party Affiliation of the President,Majority in Congress,and Sin Stock Returns

We find that in contrast to the stock market, which performs better during Democratic presidencies, “sin” stocks—publicly traded producers of tobacco, alcohol, and gaming—perform better during Republican presidencies and even more so when the Republican presidency is accompanied by a Republican majority in at least one chamber of Congress. We examine whether sin firms use contributions to establish connections with politicians and find that sin firms contribute more to Republican candidates and that these contributions are greater when Republicans are in power. We also find a positive relation between political contributions and future returns. The relation is stronger for contributions to Republicans.     

U.S. presidential cycles and the foreign exchange market

We examine the association between the foreign exchange rate of the US dollar and US presidential cycles. Results show that Republican presidencies tend to start with a strong dollar, which then depreciates over the course of the presidency. In contrast, Democratic presidencies tend to begin with a weak dollar that then appreciates. These patterns result in an apparent presidential effect in US foreign exchange rates, the direction of which depends on whether exchange rates are measured by levels or by returns.     

CEO political ideologies and auditor-client contracting

We investigate whether CEOs’ political ideology, as captured by their political contributions, is related to audit risk and, consequently, to audit pricing. We find that Republican CEOs are associated with lower inherent risk and control risk, which represent the two components of audit risk related to the firm, while their Democratic counterparts are seen to have higher risks. Consequently, Republican (Democratic) CEOs are associated with lower (higher) audit fees. The results are robust to controlling for religiosity, executive incentives and ability, obtaining alternative measures of inherent and control risk, and to using propensity score matching and entropy balancing. We further show that changes in political ideology are associated with changes in audit risk and fees. In sum, the evidence implies that auditors view the political ideology of CEOs as an important determinant of engagement risk, which may have important implications for disclosure policy.     

The Impact of Corporate Social Performance on Financial Risk and Utility: A Longitudinal Analysis

This study focuses on the wealth‐protective effects of socially responsible firm behavior by examining the association between corporate social performance (CSP) and financial risk for an extensive panel data sample of S&P 500 companies between the years 1992 and 2009. In addition, the link between CSP and investor utility is investigated. The main findings are that corporate social responsibility is negatively but weakly related to systematic firm risk and that corporate social irresponsibility is positively and strongly related to financial risk. The fact that both conventional and downside risk measures lead to the same conclusions adds convergent validity to the analysis. However, the risk‐return trade‐off appears to be such that no clear utility gain or loss can be realized by investing in firms characterized by different levels of social and environmental performance. Overall volatility conditions of the financial markets are shown to play a moderating role in the nature and strength of the CSP‐risk relationship.     

An introduction to security returns

The equity premium - the difference between the return achievable from investment in the equity market (R_M ) and the risk-free rate of return (R_F )- plays an important part in corporate finance. The expression equity premium (sometimes referred to as the equity risk premium) is used to denote the ex ante expectation of investors. The term excess return refers to the ex post achievement of stock returns over and above the risk-free return. If we compare US and UK returns, we find that total returns, real returns and the value of (R_M - R_F ) are all marginally higher for the UK. Summarized evidence appears in Table 1 and Table 6. Such greater returns may be due to an increased risk premium related to increasing unexpected inflation. Particularly important in estimating the equity risk premium is whether excess returns are measured using a geometric or an arithmetic mean return. To a significant extent, this question revolves around mean reversion in stock returns. Evidence of mean reversion is substantial, although it cannot be proved unequivocally. Given the weight of evidence of mean reversion, there may be a strong case for the use of a geometric mean with an equity premium of between 3% and 5% - or even less.     

Presidential administrations and the day-of-the-week effect in stock returns

This study examines the presence of a day-of-the-week effect over different presidential administrations. The results indicate that the day-of-the-week effect prevails during the Democratic and Republican administrations. However, the pattern of the day-of-the-week effect differs between the two presidential administrations. Specifically, the negative returns on Monday are more pronounced during the Republican than during the Democratic administrations. Therefore, explanations for the day-of-the-week effect should take into account the changing pattern of the day-of-the-week effect across presidential administrations.     

Risk,Mispricing, and Value Investing

We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.     

Do shareholder views affect corporate political activities?

In this paper, we study shareholder views on corporate political contributions. We find that, with shareholders' explicit approval, firms are more likely to have higher corporate political contribution, measured by the amount of donations to the US political parties in the next election cycle. Firm's political contributions also have a positive long-run impact on firm valuations. When analysing firm's political ideology, we find weak evidence that Democratic party may benefit more from this shareholder's support than Republican party, particularly in case of firms which have recently switched their political ideology to Democratic party. Our results show that shareholders' explicit approval has an impact on firm's engagement of political activities and imply that if the shareholders stand at the same side of the firms, firms engage more in politically-related corporate activities. Our key results are supported in a regression discontinuity design and are robust to two-way clustered standard errors.     

Determining overall risk

The risk journal literature lacks a clear and simple account of the conceptual issues involved in determining the overall risk of an action, and in explaining how risk is additive. This article attempts to bring a measure of clarity to these issues in as basic and non‐technical a way as possible. First of all, the view that risk is ‘expected harm’ is explained. The view that risk is a quantitative concept is then defended. The distinction between the risk run by doing action A in respect of possible outcome x, and the overall risk run by doing action A in general is explained, as is the position that the overall risk of A is determined by summing the risks of each possible harm that A could give rise to. The article then explains how risks can be summed over time, as long as the probabilities involved are determined according to probability theory. Finally, the article explains that in a doing a risk‐benefit analysis of A, positive aspects of a possible outcome x, where x is harmful on balance, must be incorporated into x's level of harm rather than incorporated into the benefit side of the risk‐benefit analysis of A.     

Are red or blue companies more likely to go green? Politics and corporate social responsibility

Using the firm-level corporate social responsibility (CSR) ratings of Kinder, Lydenberg, Domini, we find that firms score higher on CSR when they have Democratic rather than Republican founders, CEOs, and directors, and when they are headquartered in Democratic rather than Republican-leaning states. Democratic-leaning firms spend $20 million more on CSR than Republican-leaning firms ($80 million more within the sample of S&P 500 firms), or roughly 10% of net income. We find no evidence that firms recover these expenditures through increased sales. Indeed, increases in firm CSR ratings are associated with negative future stock returns and declines in firm ROA, suggesting that any benefits to stakeholders from social responsibility come at the direct expense of firm value.     

Forward exchange rates as predictors of future spot rates and the efficiency of the foreign exchange market

The theory of informationally efficient markets (EMIT) is applied to the foreign exchange market and some of its operational implications are illustrated. The EMIT is joined with alternative models of the equilibrium return on the foreign exchange market: the Pure Expectations Hypothesis, the Modern Theory and tentative formulations of return as a function of risk. The alternative joint Hypotheses are rejected by the data but this does not necessarily imply the rejection of EMIT. The rejection may be due to the inadequacies of the equilibrium return models used, notwithstanding the fact that the risk premium has been captured, to a certain extent, in the empirical tests and the evidence against the EMIT weakened.     

Corporate lobbying,CEO political ideology and firm performance

In this paper, we investigate the influence of CEO political orientation on corporate lobbying efforts. Specifically, we study whether CEO political ideology, in terms of manager-level campaign donations, determines the choice and amount of firm lobbying involvement and the impact of lobbying on firm value. We find a generous engagement in lobbying efforts by firms with Republican leaning-managers, which lobby a larger number of bills and have higher lobbying expenditures. However, the cost of lobbying offsets the benefit for firms with Republican CEOs. We report higher agency costs of free cash flow, lower Tobin's Q, and smaller increases in buy and hold abnormal returns following lobbying activities for firms with Republican managers, compared to Democratic and Apolitical rivals. Overall, our results suggest that the effects of lobbying on firm performance vary across firms with different managerial political orientations.     

Book–to–Market Equity, Distress Risk, and Stock Returns

This paper examines the relationship between book–to–market equity, distress risk, and stock returns. Among firms with the highest distress risk as proxied by Ohlson's (1980) O–score, the difference in returns between high and low book–to–market securities is more than twice as large as that in other firms. This large return differential cannot be explained by the three–factor model or by differences in economic fundamentals. Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements, and the book–to–market effect is largest in small firms with low analyst coverage.     

The Comovement of US and UK Stock Markets

US and UK stock returns are highly positively correlated over the period 1918–99. Using VAR‐based variance decompositions, we investigate the nature of this comovement. Excess return innovations are decomposed into news about future dividends, real interest rates, and excess returns. We find that the latter news component is the most important in explaining stock return volatility in both the USA and the UK and that stock return news is highly correlated across countries. This is evidence against Beltratti and Shiller's (1993) finding that the comovement of US and UK stock markets can be explained in terms of a simple present value model. We interpret the comovement as indicating that equity premia in the two countries are hit by common real shocks.     

The perception of time,risk and return during periods of speculation

Abstract

What return should you expect when you take on a given amount of risk? How should that return depend upon other people's behaviour? What principles can you use to answer these questions? In this paper, I approach these topics by exploring the consequences of two simple hypotheses about risk.

The first is a common-sense invariance principle: assets with the same perceived risk must have the same expected return. It leads directly to the well known Sharpe ratio and the classic risk-return relationships of arbitrage pricing theory and the capital asset pricing model.

The second hypothesis concerns the perception of time. I conjecture that in times of speculative excitement, short-term investors may instinctively imagine stock prices to be evolving in a time measure different from that of calendar time. They may perceive and experience the risk and return of a stock in intrinsic time, a dimensionless time scale that counts the number of trading opportunities that occur, but pays no attention to the calendar time that passes between them.

Applying the first hypothesis in the intrinsic time measure suggested by the second, I derive an alternative set of relationships between risk and return. Its most noteworthy feature is that, in the short-term, a stock's trading frequency affects its expected return. I show that short-term stock speculators will expect returns proportional to the temperature of a stock, where temperature is defined as the product of the stock's traditional volatility and the square root of its trading frequency. Furthermore, I derive a modified version of the capital asset pricing model in which a stock's excess return relative to the market is proportional to its traditional beta multiplied by the square root of its trading frequency.

I also present a model for the joint interaction of long-term calendar-time investors and short-term intrinsic-time speculators that leads to market bubbles characterized by stock prices that grow super-exponentially with time.

Finally, I show that the same short-term approach to options speculation can lead to an implied volatility skew.

I hope that this model will have some relevance to the behaviour of investors expecting inordinate returns in highly speculative markets.     

On user costs of risky monetary assets

Summary. We extend the monetary-asset user-cost risk adjustment of Barnett, Liu and Jensen (1997) and their risk-adjusted Divisia monetary aggregates to the case of multiple non-monetary assets and intertemporal non-separability. Our model can generate potentially larger and more accurate CCAPM user-cost risk adjustments than those found in Barnett, Liu and Jensen (1997). We show that the risk adjustment to a monetary assets user cost can be measured easily by its beta. We show that any risky non-monetary asset can be used as the benchmark asset, if its rate of return is adjusted in accordance with our formula. These extensions could be especially useful, when own rates of return are subject to exchange rate risk, as in Barnett (2003).We thank participants at the 11^th Global Finance Annual Conference, Yuqing Huang, and an anonymous referee for helpful comments and suggestions.     

Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms

Do the low long‐run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book‐to‐market borrowers as systematically riskier than larger borrowers with low book‐to‐market ratios, consistent with the asset pricing approach in Fama and French (1993) . Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk‐based explanations for the observed equity returns following IPOs and SEOs.