Political Events and the Stock Market: Evidence from Israel

ABSTRACT The past decade has seen increasing activity regarding the peace process between Israel and its Arab neighbors. In this paper I study the return patterns of the Tel Aviv Stock Exchange index and of Israeli firms' stocks traded in the United-States following announcements of news related to the peace process. I find that returns on the Tel Aviv Stock Exchange following political events are more extreme than returns on days that do not follow political events. This pattern is also apparent in returns of dually listed stocks (those traded both in the US and in Israel). The pattern is not present in Israeli stocks that are traded only in the US. JEL: GI S, F31 Keywords: Political event; Stock market; Israel; Middle East; News I. INTRODUCTION The dissemination of news into asset prices has attracted the attention of financial economists for decades. Many studies examined the effects of various pieces of information (e.g. earnings announcement, macroeconomic news, political news) on asset prices. The general conclusion in these studies is that stock prices are affected by new information regarding firms' expected future cash flows and/or future discount rates. In this paper, I explore the relation between stock prices and political news. In particular, I study the effect of news regarding the peace process in the Middle East on stock prices of Israeli companies. The results add to the literature studying factors that move the stock market. Fama (1990) and Schwert (1990) show that only 50% of the market's stock price variation can be explained, ex post, by real economic activity. Roll (1988) presents similar results for individual firms' stock price variation. Researches have wondered why we can't explain more of the variation in stock prices even with the benefits of hindsight. As a result, researchers turned into examining other factors that potentially influence stock price movements and that were omitted from previous studies. For example, Bittlingmayer (1992) studies changes in public policy towards business, in particular antitrust legislature, and their impact on stock prices. Other studies look at the political arena to try and find parts of the "missing variation" claiming that economic events are strongly related to political events. This type of analysis looks for political events that do not have an ex-post influence on economic activity, because if they do, their effect is included in the explained variation of previous studies similar to Fama (1990) and Schwert (1990). Thus, the role of political events in explaining stock market variation is not only through their impact on future variables such as cash-flows, but is also through their effect on the degree of uncertainty in the stock market. This uncertainty may or may not translate into changes in future variables such as earnings or aggregate output, but it certainly has a discernible effect on current prices. Bittlingmayer (1998) shows that political uncertainty affected both stock market volatility and output in post-WWI Germany. Schwert (1989) conjectures that the excess volatility of the US stock market during the great depression was an example of a "peso problem" in the sense that there was a high uncertainty of whether the economic system would stay intact. The purpose of this paper is to learn how the Israeli stock market reacts to changes in the Israeli political environment and especially to events related to the peace process. My sample period is limited to the years 1993-1997 because the high variability of political changes in the Middle East during this period provides a good opportunity to perform more powerful tests of this question. I study the behavior of stock returns immediately following political events. Two measures of stock performance are investigated. The first is the Israeli Stock Exchange index (the Mishtanim Index) and the second is a self-constructed index of Israeli stocks traded in the US. …