Political Cycles and the Stock Market

Abstract

Contrary to the widespread opinion that "Republicans are good for business," we find that the average excess returns in the stock market are higher under Democratic presidents. The empirical difference between Republican and Democratic mandates, which is about 9% annually for the value-weighted portfolio and 16% for the equally-weighted portfolio, is economically and statistically significant, and is also robust in subsamples. Moreover, there is a remarkable monotonicity in the difference of returns for size-decile portfolios, from \% for large firms to about 20% for small firms. We test three plausible explanations of the above findings. First, we test the hypothesis that the observed correlation is entirely due to political variables proxying for business-cycle factors. Second, we explore whether the observed relation can be explained by "election shocks," i.e whether the effect is concentrated around the election dates, when new information is revealed. Lastly, we investigate the possibility that varying volatity and price of risk during the two presidential regimes might account for our findings. We reject all three hypotheses. As it stands, the difference in excess returns during Republican and Democratic presidencies is a puzzling feature of the data that cannot easily be accommodated by asset pricing models.