John G. Powell

The Persistent Presidential Dummy

Is a Republican or a Democratic party president better for the stock market? Although many observers discuss this issue in only casual terms, one recently published academic study claims to have documented that the market does significantly better under Democratic party administrations. Despite widespread publicity about this in the financial press, the studys results and conclusions are biased by faulty statistical tests. Once the methodology is corrected, the differences in stock market returns under different political parties turn out not to be meaningful. The lessons here extend well beyond the presidential political party effect. Proper research design is essential if we are to reach correct conclusions.

Measuring the Relative Efficiency of Fund Management Strategies in New Zealand Using a Spreadsheet-based Stochastic Data Envelopment Analysis Model

Portfolio managers can face cash outflows and possible job loss if their short-term performance temporarily lags behind the competition. The practical relevance of this problem is accentuated in New Zealand where the small number of predominantly resource-based companies has meant that a few unfortunate stock picks by New Zealand fund managers have often led to sharp and sudden divergences amongst managed fund performance. This concern over relative efficiency suggests that data envelopment analysis (DEA) could be helpful when New Zealand fund managers select portfolios, but a stochastic data envelopment analysis (SDEA) approach is necessary due to the chance element in short-term portfolio management performance. This paper proposes a spreadsheet-based numerical SDEA model based upon @RISK in order to alleviate this short-term relative performance aspect of New Zealand portfolio management. The predictive ability of the SDEA model for avoiding portfolios which will display subsequent short-term underperformance is demonstrated using New Zealand investment return data.

Stock market political cycles in a small, two-party democracy

Real stock market returns in New Zealand are lower when the left-leaning Labour party is in power than under National party governments, in contrast to the USA where returns are higher under Democratic presidents than under right-leaning Republicans. The difference in real stock market returns between National and Labour is not reversed even when account is taken of the effect of the US political cycle and returns on New Zealand. The results of the study therefore suggest that the presidential puzzle does not transfer directly to other countries with two similar party democracies.

Detection of Financial Time Series Turning Points: A New CUSUM Approach Applied to IPO Cycles

This paper presents a new Cumulative Sum approach for the detection of turning points in financial time series that are subject to cyclical mean level and volatility regime shifts. The new CUSUM approach is applied to the problem of detecting turning points in “hot issue” markets for Initial Public Offerings (IPOs), thus providing a multi-dimensional characterization of states of the IPO cycle.

Common Divisors, Payout Persistence, and Return Predictability

In the finance and accounting literature, the use of a common divisor in the dependent and independent variables of ordinary least-squares regressions is commonplace. What goes less recognized, however, is that their use induces spurious correlation between the regression variables and invalidates standard testing procedures. This paper analyses the common divisor problem by outlining analytical results concerning the expected R2 and providing a simulation procedure that generates test statistics from which critical values can be drawn. To illustrate the procedure, we re-investigate payout yield return predictability findings that have appeared in the literature and show that the results are spurious.

Foreign direct investment and international stock market integration

This paper examines whether foreign direct investment between countries fosters stock market integration. Empirical tests demonstrate that both the flow and the level of bilateral foreign direct investment between countries explain country-pair stock market integration. More specifically, higher bilateral foreign direct investment levels and flows increase Australia’s stock market integration with its major trade partners.

Volatility prediction during prolonged crises: Evidence from Korean index options

Abstract This paper examines KOSPI200 index option prices in order to investigate whether index option implied volatilities foreshadowed the 1997 economic crisis in Korea. Results indicate the absence of strong fears of an impending market downturn prior to the crisis. Put option implied volatilities rose sharply as the crisis intensified, however, and the difference between put and call implied volatilities reached extreme levels compared to results found in previous studies of financial crises in developed markets. The study indicates that option traders reacted to the crisis rather than predicting its onset, perhaps reflecting the youthfulness of the market. Traders also appear to have learned from the crisis as it intensified.

A Test for Long-Term Cyclical Clustering of Stock Market Regimes

This paper finds that observed monthly United States stock index returns are consistent with an underlying mechanism of shifts in regimes amongst multiple states with differing means and volatility. An issue of especial interest is whether long-term clustering of regimes gives rise to stock market cycles. The paper therefore introduces a likelihood ratio test for long-term clustering of regimes. Clustering of regime presence tends to involve much longer term cycles than the bull and bear market cycles identified by Pagan and Sossounov (2003), thus extending the research issues that are associated with the analysis of mean returns using multiple state regime-switching models.

Endowment Warrant Valuation

An important use of derivatives is to rearrange the cash flows on an underlying asset. One reason to do this to reduce the initial investment needed to take a long position in the underlying stock - in other words, to increase leverage. Buying an in-the-money call option is a substitute for buying on margin, for example. But, unlike margin buyers, holders of ordinary calls do not receive the dividend flow from the underlying shares, meaning they do not participate in corporate earnings that are paid out in dividends. Endowment warrants, issued by major banks in Australia and New Zealand, are payout protected calls with maturities of around ten years, that present a way for ordinary investors to make long-term equity investments without either missing out on the dividends or bearing the expense and potential problems of buying on margin. This article describes these new instruments and shows that traditional option valuation models do a good job in pricing them.

Valuation uncertainty risk compensation and IPO prospectus earnings forecasts

Younger, riskier, less credible firms do not voluntarily supply initial public offering prospectus earnings forecasts. Nondisclosure increases valuation uncertainty risk, thus necessitating higher first-day underpricing and long-run performance as compensation.