STOCK MARKET CONSEQUENCES OF POLITICAL VIBRANCY

• DOI: http://doi.org/10.1111/jfir.12218
• Date: 01 August 2020
• Author: Jung Chul Park,Christos Pantzalis
• Published date: 01 August 2020

The Journal of Financial Research Vol. XLIII, No. 3 Pages 491–542 Fall 2020

DOI: 10.1111/jfir.12218

STOCK MARKET CONSEQUENCES OF POLITICAL VIBRANCY

Christos Pantzalis and Jung Chul Park

University of South Florida

Abstract

We define areas with strong geographic ties to powerful politicians as politically

vibrant and show that they are characterized by greater value‐relevant information

generation and symptomatic of equity market segmentation. Political vibrancy

entails greater levels of local bias and local comovement and has two important

return predictability implications. First, it enhances local institutions’informational

advantages; their trades’ability to forecast local stock returns exceeds that of

nonlocal institutions. Second, in support of the view that information diffuses slowly

into prices, stock returns of firms from politically vibrant areas predict returns of

similar firms in other areas.

JEL Classification: G11; G12; H10

I. Introduction

The U.S. political system of representative democracy is intended to provide a

fairly even population‐adjusted representation of the country’s different locations

in political bodies, such as state legislatures, Congress, and the president’s

administration. Nevertheless, there are naturally occurring geographic clusters of

higher levels of political activity and representation, where local communities’

ties to politicians are much stronger than elsewhere. Geographic proximity and

associated homophily between politicians, their associates, and local citizens

makes it more likely that commonly beneficial initiatives in government policy

can be identified and advanced through the formation of political organizations

and/or through informal political connections. Gimpel, Lee, and Kaminski (2006)

argue that spatial proximity lowers the barriers to organization by improving lines

of communication and the formation of social ties. Busch and Reinhardt (2000)

show that geographically concentratedfirmsaremorelikelytoorganize.In

addition, Busch and Reinhardt (1999) and McGillivray (1997) provide evidence

that such firms are more likely to gain protectionist concessions from government

with respect to trade policy.

We thank Murali Jagannathan (editor), an anonymous referee, and seminar participants at the University of

South Florida, the 2019 Financial Management Association Annual Meeting, 2016 Southern Finance

Association Annual Meeting, 2016 Korea Finance Associations Joint Conference, and 2016 Magnolia Finance

Conference for their many insightful and constructive comments and suggestions. Jung Chul Park acknowledges

financial support from the Center for Analytics and Creativity of the University of South Florida.

491

© 2020 The Southern Finance Association and the Southwestern Finance Association

We conjecture that areas with stronger geographic ties to powerful political

actors are innately more “politically vibrant,”in the sense that politics is more likely to

provide a dominant common backdrop for locals’interactions with each other and to

the way they conduct business. Politicians develop ties to their “home base,”which

comprises their constituency areas as well as areas where they live or work. Wherever

there is an abundance of such ties, local communities become more politically vibrant;

people with ties to local networks of political actors and their associates comprise an

extended network of political information exchange that typically would not exist

outside these politically vibrant clusters. Consequently, politically vibrant communities

should be more likely to participate in political elections and have better access to

political information. Greater production of value‐relevant political information in

these communities should be especially beneficial for local investors who should be

more likely to use this information as a filter when absorbing and analyzing the value

implication of news related to the overall market or to local firms. Whether an area’s

political vibrancy,

1

thrust by geographic ties to powerful politicians, can cause local

investors’information set to significantly deviate from the norm and thereby affect

stock market outcomes has not been investigated in the literature.

2

We aim to fill this

void through an empirical examination of U.S. publicly listed stocks over a recent

47‐year period.

We postulate that an area’s degree of political vibrancy can influence the

extent to which a firm’s stock price reflects market conditions in its home locale, and

therefore it can be symptomatic of domestic equity market segmentation. In this

context, geographic ties between firms’headquarters locations and powerful politicians

can serve as pathways of value‐relevant information flow into stock prices and,

consequently, as the basis for return predictability strategies. Essentially, we argue that

information related to value‐relevant political developments that affect markets, the

most common of which are new policy initiatives and related legislative activity, can

1

We clarify that in essence the political vibrancy effect on stock returns is not restricted to local firms’

political connections but rather is based on market segmentation and slow information diffusion from areas

where politics dominates the local stocks’pricing narrative to other areas where there is no (or less) such

vibrancy. Sophisticated local investors (e.g., local institutions) in vibrant areas have both better access to and

more trust in the information they receive from networking with local businesses and powerful politicians.

Therefore, their local stock trades incorporate this information into local stock prices first. Subsequently, as the

prices of similar stocks in nonvibrant communities do the same with delay, they could generate the return

predictability patterns.

2

The consensus in the literature seems to be that, on average, benefits from ties to politicians exceed the

costs of establishing and maintaining these connections. For example, Roberts (1990), Fisman (2001), and

Faccio (2006) provide evidence of net gains from political ties by using a methodology that highlights the

sensitivity of connections based on campaign contributions or personal and family ties to events such as the

establishment or termination of a connection. More recently, Faccio and Parsley (2009) and Pantzalis and Park

(2014) show that connections based on geographic ties are valuable, yet risky. Faccio and Parsley focus on

location, which forms a powerful basis for political connections (Roberts 1990; Siegel 2007) and use sudden

deaths by politicians to identify the effect of political connections on the value of firms located in the geographic

area with which the politician is most associated. Their evidence indicates that geographic ties account for a large

portion of firm value. Pantzalis and Park show that the proximity of firm headquarters to political power centers

(state capitals) is associated with higher abnormal returns, and they argue that this effect is rooted in investor

perception that there is more political risk associated with social networks linking politicians and firms.

492 The Journal of Financial Research

be assessed in a more straightforward manner by sophisticated investors in politically

vibrant areas. This happens because vibrancy, through its endogenous interactions

among investors, businessmen, and politicians living in the area, causes spillovers that

allow new information shocks pertaining to a local firm to be transmitted to its

neighbors.

3

Hence, given investor propensity to prefer nearby firms’stocks (Coval and

Moskowitz 1999), value‐relevant news is reflected first in the prices of firms located in

politically vibrant areas. In contrast, investors residing far from politically vibrant

areas, and therefore lacking access to information that emanates from the network

linking these communities with political actors, are less adept at deciphering in a timely

fashion the value implications of political information shocks. Therefore, we posit that

stock prices of firms in politically nonvibrant areas respond to political information

shocks with delay relative to their peers from politically vibrant areas.

4

This gradual

diffusion of information leads to stock return predictability running from firms located

in politically vibrant areas to firms located outside these areas.

There are two mechanisms that can facilitate faster diffusion of value‐

relevant information into stock prices of firms located in politically vib rant areas.

First, communities with greater political vibrancy typically exhibit greater levels

of sociability (Brown et al. 2008) and political activism (Bonaparte and

Kumar 2013). In communities with greater sociability, information travels from

one investor to another faster because of a stronger “word‐of‐mouth”effect.

Political activism implies that local investors follow both political and financial

news more intensely, have lower information‐gathering costs, and therefore are

expected to exhibit greater stock market participation. Bonaparte and Kumar

(2013) conjecture that politically active people follow political news more

actively and are therefore more likely to be exposed to financial news. Thus, they

hypothesize that politically active investors have lower information‐gathering

costs and higher propensity to participate in the market. Wilson (1973)

distinguishes among material, purposive, and solidary motives for political

participation. We argue that geography can affect each of the aforementioned

types of motives. Thus, a geographic area’s abundance of connections to

politicians may increase the local population’s interest in, as well as its exposure

and sensitivity to, political news. Also, it is conceivable that because investors in

communities with strong geographic ties to powerful politicians have better

access to social networks linking the politicians with local citizens and business

community, they develop a greater level of trust in the stock market (Guiso,

Sapienza, and Zingales 2008), making them more likely to acquire and analyze

value‐relevant political information.

3

This spillover effect of urban vibrancy and its role in the local effects on corporate investment

expenditures is shown in Dougal, Parsons, and Titman (2015).

4

The literature contains many examples of the responsiveness of politically connected firm stock prices to

information shocks (e.g., Roberts 1990; Fisman 2001; Faccio and Parsley 2009). Recent evidence also shows that

cash‐flow‐relevant information processing is more straightforward when firms are politically active. For

example, corporate political strategies act as a hedging mechanism that effectively reduces the effect of policy

risk on firms’cost of debt (Bradley, Pantzalis, and Yuan 2016) and stock returns (Kim et al. 2019).

493Stock Market Consequences