Long Georgia, Short Colorado? The Geography of Return Predictability
55 Pages Posted: 17 Jan 2009
Date Written: January 16, 2009
This study investigates whether local stock returns vary with local business cycles in a predictable manner. We conjecture that, in the presence of local bias and incomplete risk sharing, local macroeconomic variables that characterize local business cycles would predict the returns of local stocks. In particular, during local economic recessions, the average returns of local stocks would increase as local risk aversion increases and the ability of local investors to smooth consumption declines. Consistent with this conjecture, we find that U.S. state portfolios earn higher (lower) returns when state-level unemployment rates are higher (lower) and state investors face stronger (weaker) borrowing constraints. During the 1980-2004 period, trading strategies that exploit this state-level predictability earn annualized risk-adjusted return of over 7 percent. The evidence of predictability is stronger among less visible firms and in regions in which investors exhibit stronger local bias and hold more concentrated portfolios. Overall, our results indicate that the stock return generating process contains a predictable local component.
Keywords: Local Bias, U.S. States, Time-varing Risk Sharing and Risk Aversion
JEL Classification: C23, E17, G12
Suggested Citation: Suggested Citation