Political uncertainty and abnormal market conditions are thought to have a notable impact on institutional trading. The author finds, contrary to perceptions, that institutions are net buyers (sellers) during abnormal market declines (increases). The author also finds that periods of political uncertainty negatively affect institutional buying activity and increase market impact cost.
What’s Inside?
The author examines the impact of abnormal, unstable market conditions and political uncertainty on institutional trading behavior. He finds, contrary to perceptions, that institutions are net buyers (sellers) during abnormal market declines (increases). In effect, institutions are net providers of liquidity during abnormal market conditions. The author also finds that periods of political uncertainty negatively affect institutional buying activity and increase market impact cost during market declines.
How Is This Research Useful to Practitioners?
Previous research has supported the idea that institutional investors destabilize the market by herding (i.e., trading on the same side of the market during abnormal market conditions). Intuition would suggest that political uncertainty has a significant positive impact on capital flight, but the author finds that institutional investors are net buyers during abnormal market decreases and net sellers during abnormal market increases.
He examines four scenarios to isolate differences between abnormal market advances/declines in general and abnormal market advances/declines during periods of high political uncertainty. Institutional investors face higher price impacts during times of high political uncertainty and abnormal market conditions, particularly if they are moving in the same direction as the market and demanding liquidity. Institutional investors pay for liquidity when buying in rising markets and selling in falling markets. In abnormal market declines, institutional sells face a 2.98% price impact. In abnormal market increases, institutional buys generate a price impact of 3.24%. In other words, institutions buying during abnormal market increases seem to face a higher price impact than those selling during abnormal market declines.
How Did the Author Conduct This Research?
To proxy for daily political uncertainty, the author uses an index based on newspaper archives from Access World News NewsBank service, which searches U.S. newspaper articles that include at least one term from each of three sets. The first set is “economic” or “economy”; the second set is “uncertain” or “uncertainty”; the third set is “legislation,” “deficit,” “regulation,” “Congress,” “Federal Reserve,” or “White House.” The more articles that reference terms from each of these three sets, the greater the index level of political uncertainty.
Abnormal market conditions are defined as a day when the CRSP value-weighted market index return is more than two standard deviations above or below the mean during the sample years.
Abstractor’s Viewpoint
Investment practitioners should find it interesting that institutional investors are net buyers during abnormal market decreases and net sellers during abnormal market increases and consequently do not exacerbate or cause abnormal market movements. The author’s findings suggest that institutional investors’ net buying activity does decline at a statistically significant level because of political uncertainty aversion, but it is very difficult to measure political uncertainty.
Previous studies have attempted to proxy political instability by measuring “cabinet changes”—that is, the number of times in a year when a new premier is named and/or 50% or more of cabinet posts are occupied by new ministers. The author restricts his study of political uncertainty to newspapers in the United States. It would be interesting to confirm the results using such tools as Google Trends, which tracks the number of times a particular search term is entered relative to the total search volume across various regions of the world and in various languages.