Political Sentiment and Predictable Returns

Abstract:     
This study examines the impact of changing political environment on the stock market. We find that as the political climate changes, there are systematic shifts in the portfolio compositions of investors, which generates predictable patterns in stock returns. A trading strategy that attempts to exploit this predictability pattern generates an annualized risk-adjusted performance of about six percent during the 1939 to 2011 period. The evidence of predictability spans an economically meaningful segment of the market (17-27%) and is somewhat stronger during the more recent time period. Return predictability is almost twice as strong when the challenger party is victorious, especially when there is a transition of power from the Democratic to the Republican Party. The predictability patterns are also stronger during high attention months surrounding the elections and years one and four of the Presidential term when the level of political awareness is higher. Overall, our results establish a strong link between politics and financial markets.

Number of Pages in PDF File: 49

working papers series