01 Jun 2014

Research Brief: Capitol Gains

How a bill forecasts the market
by Garry Emmons


Psst… looking for a hot stock tip? Forget the Wall Street Journal. Try the Congressional Record.

HBS professors Lauren Cohen and Christopher Malloy, with Dartmouth's Karl Diether, analyzed the complete legislative record of all US senators and representatives from the 101st to 110th Congresses. After assessing the main purpose of each bill and classifying each according to 49 industry categories, they watched how legislators voted when their home state's GDP was significantly driven by firms that would be affected by the legislation. Looking at an oil-rich state, for example, the financial impact (positive or negative) of a bill affecting the state's petroleum producers and related companies could be inferred by following the votes of the state's lawmakers. The politicians, after all, are the people most knowledgeable about the contents of the bills due to a vested political interest in their outcomes. Using this model, the researchers discovered a phenomenon undetected by markets: After passage of such signal legislation, firms in the affected industries yielded abnormally robust returns for investors, as reported in the December 2013 issue of the Journal of Financial Economics.

"It might seem obvious that legislation that either supports or challenges an industry would have predictable financial fallout for a state's firms engaged in that industry," says Cohen. "But the markets have never understood how to chart such legislation's repercussions or figure out how to systematically capitalize on it."

To further explain his model, Cohen cites this year's controversial farm bill, which passed in the Senate by a vote of 68 to 32, with support from 83 percent of Democrats and 49 percent of Republicans. Cohen and his colleagues looked at "industry-tied votes" by "interested" legislators—senators from states where agriculture was responsible for a high percentage of the state's GDP—and compared those votes with the votes of "uninterested" legislators (from non-farm states). In Nebraska and the two Dakotas—the top three states in terms of agriculture as a percentage of state GDP—all six of their senators voted for the bill, a much higher figure than the 68 percent of senators in favor as a body. Significantly, four of the six senators were Republicans, breaking ranks with the nay-saying majority of the GOP. The result? In the two weeks after the bill became law, "the performance of the agriculture industry versus the market overall amounted to a difference of 320 basis points," Cohen notes. "That is massive."


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