Underreaction to Political Information and Price Momentum

• Published date: 01 September 2019
• Author: Stefanos Delikouras,Alok Kumar,Da Ke,Jawad M. Addoum
• DOI: http://doi.org/10.1111/fima.12241
• Date: 01 September 2019

Underreaction to Political Information

and Price Momentum

Jawad M. Addoum, Stefanos Delikouras, Da Ke, and Alok Kumar∗

In this study, we examine whethermomentum in stock prices is induced by changes in the political

environment. We find that momentum profits are concentrated among politically sensitive firms

and industries. From 1939 to 2016, a trading strategy with a long position in winner portfolios

(industries or firms) that are politically unfavoredand a short position in losers that are politically

favored does not generate significant momentum profits. Furthermore, our political-sensitivity-

based long-short portfolio explains 23% to 27% (42% to 43%) of monthly stock (industry)

momentum alphas. This explanatory power is concentrated around presidential elections, when

the level of political activity is high. Collectively, our results suggestthat investor underreaction

to political information generates momentum in stock and industry returns.

Momentum in stock returns is perhaps one of the most robust empirical patterns identified

in the recent asset pricing literature. Although there is general agreement in the literature that

momentum profits are large and pervasive (e.g., Asness, Moskowitz, and Pedersen, 2013), there

is considerable debate about the economic determinants of momentum in stock returns. On the

one hand, Berk, Green, and Naik (1999), Johnson (2002), Sagi and Seasholes (2007), and Liu and

Zhang (2008, 2014) propose risk-based explanations of momentum profits. On the other hand,

Barberis, Shleifer, and Vishny(1998), Hong and Stein (1999), and Grinblatt and Han (2005) posit

that momentum in returns is driven by underreaction to news. Moreover, Hong, Lim, and Stein

(2000) demonstrate that slow information diffusion is an important driver of momentum in stock

returns.

In this article, we identify a new economic mechanism that generates momentum in stock prices.

Specifically, we posit that sensitivity of firms and industries to a changing political environment

is an important driver of momentum in returns. Our key insight is that certain types of firms and

industries are more likely to benefit from the policies of the Republican or the Democratic party.

Similarly, certain market segments may be more adversely affected by specific party policies.

For example, environmentally friendly firms may expect to benef it from the policies of the

Democratic party, whereas industries such as defense, tobacco, and guns may be favored by a

Republican regime.

If shifts in the political climate can be predicted, the stock prices of certain firms and industries

would start to rise or fall in anticipation of a shift in the political climate. If investors incorporate

Wewould like to thank an anonymous referee, Sandro Andrade,Constantinos Antoniou, Tim Burch, Vidhi Chhaochharia,

Douglas Emery, Will Goetzmann, Simon Gervais, John Griffin, Bing Han (Editor), Byoung-Hyoun Hwang, George

Korniotis, Alexei Ovtchinnikov, David Sraer, Avanidhar Subrahmanyam, Sheridan Titman, and seminar participants

at the 2015 American Finance Association Meetings and the University of Miami for helpful comments and valuable

suggestions.

∗JawadM. Addoum is an Assistant Professor of Finance and Robert R. Dyson Sesquicentennial Fellowin the S.C. Johnson

College of Business at Cornell University in Ithaca, NY.Stefanos Delikouras is an Assistant Professor of Finance in the

Miami Business School at the University of Miami in Coral Gables,FL. Da Ke is an Assistant Professor of Finance in the

Darla Moore School of Business at the University of South Carolinain Columbia, SC. Alok Kumar is the Gabelli Asset

Management Professorof Finance in the Miami Business School at the University of Miami in Coral Gables, FL.

Financial Management •Fall 2019 •pages 773 – 804

774 Financial Management rFall 2019

news about a potential shift in the political environment with some delay, because either the

outcome is not certain or the investors are slowerto respond to perceived changes in the economic

environment, stock prices may not adjust immediately. This adjustment process may extend over

several weeks or even months.

Investors mayf ind interpretation of news tied to the political cycle difficult for several reasons.

First, investors may perceive the party in power to be only a noisy signal of economic policies

and hence may not anticipate differences over partisan cycles. Second, because of the relatively

small sample of presidential cycles, investors may find it difficult to identify the systematic

effects associated with the party in power. Finally, such systematic effects may be time varying,

making the problem of identifying and interpreting new political information especially difficult

for investors.

Given the potential delay in the interpretation of new political information, valuations of firms

and industries that are expected to benefit from the new political regime should gradually rise

surrounding the change in ruling party. Similarly,if the new party is expected to affect other firms

adversely, these fir ms’ valuations should gradually decline following the change in the political

environment. Overall, our main conjecture is that around political events,changes in the political

climate induce momentum in stock prices.1More generally, we posit that even during other

periods, time variation in the political environment generates time-varying momentum profits.

This key conjecture is motivated bya g rowingliterature in f inance that establishes a link between

the political environment and stock market returns.

Specifically, Cooper, Gulen, and Ovtchinnikov (2010), Belo, Gala, and Li (2013), and Kim,

Pantzalis, and Park (2012) provide evidence of return predictability induced by political connec-

tions, government spending, and geography-based political alignment, respectively. The political

climate is also an important determinant of investors’ portfolio decisions. For example, Bona-

parte, Kumar, and Page (2012) and Addoum and Kumar (2016) show that investors adjust their

portfolios following changes in the political environment. In particular, Addoum and Kumar

(2016) 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 (2016) do not examine the impact of shifts in the political

environment on momentum profits.

Our article links this growing literature on politics to the literature on price momentum and

demonstrates that momentum profits are influenced by the political climate. In our empirical

analysis, we identify politically sensitive firms and industries and show that a large part of

momentum profits can be attributed to underreaction to political infor mation. 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 (2016) method and classify

momentum winner and loser portfolios into politically consistent (i.e., favored) and politically

inconsistent (i.e., unfavored) categories.

We find that the politically consistent momentum strategy, which takes a long position in

stocks (industries) that are both winners and politically favored and a short position in stocks

(industries) that are both losers and politically unfavored, outperforms the standard momentum

strategy by 5.04% (2.01%) on an annual basis during our 1939-2016 sample period. Furthermore,

1To help build intuition for this mechanism, we conduct a case study examining the evolution of industry momentum

portfolio components in the months following the 2016 presidential election. We show that the resulting change in the

political environmentinduced a gradual shift in momentum decile por tfolio classifications, with some momentum winners

even becoming losers (and vice versa) in the six to nine months after the election. See Appendix A for details.

Addoum, et al. rUnderreaction to Political Information and Price Momentum 775

Figure 1. Cumulative Gains for Different Momentum Portfolios

This figure presents cumulative monthly log-returns for investingin: (1) the politically consistent momentum

portfolio, (2) the standard momentum portfolio, (3) the politically inconsistent momentum portfolio, and

(4) the market excess return portfolio. The y-axis shows cumulative log returns for each portfolio. On the

right side of the plot, we present final dollar values for each of the four long-short strategies.

$441,458 (PCM)

5$81,609 (SM)

4

$3,958 (PIM)

$3,014 (RMRF)

3

2

1

0

40 45 50 55 60 65 70 75 80 85 90 95 00 05 10 15

Calendar Time (January 1939 to December 2016)

log10(1+$value of investment)

the politically inconsistent momentum strategy, which has a long position in stocks (indus-

tries) that are winners but politically unfavored and a short position in stocks (industries) that

are losers but politically favored, generates returns that are statistically indistinguishable from

zero.

Figure 1 highlights the importance of political sensitivity in momentum returns. We find that

during 1939-2016, a $1 investment in the politically consistent momentum strategy grows to

more than five times the value of $1 invested in the standard momentum strategy and more

than 100 times the value of $1 invested in the politically inconsistent momentum strategy. This

evidence indicates that the profitability of the momentum strategy depends critically on the

sensitivity of firms to the changing political climate. When the political environment is misaligned

with the winner and loser portfolios, the momentum strategy yields economically insignificant

profits.

In additional tests, we investigatethe ability of a political-sensitivity-based long-short portfolio

(POL) to explain the time variation in momentum profits. POL represents the difference between

the value-weighted returns of a portfolio of firms that are expected to benefit from the new

political environment and the value-weighted returns of firms that are expected to be most

adversely affected by the new political environment. In the presence of several additional asset

pricing factors, we find that a large portion of the time-series of momentum profits can be

explained by the time variation in POL returns. The incremental explanatory power of our

political sensitivity measure is economically meaningful as it eliminates approximately 23% to

27% of monthly momentum alphas during 1939-2016.

We also examine the relation between returns to POL and a momentum strategy formed using

industry returns. Moskowitz and Grinblatt (1999) suggest that industry momentum drives much of