Political Cycles and Stock Returns

Abstract

We develop a model of political cycles driven by time-varying risk aversion. Agents choose to work in the public or private sector and to vote Democrat or Republican. In equilibrium, when risk aversion is high, agents elect Democrats---the party promising more redistribution. The model predicts higher average stock market returns under Democratic presidencies, explaining the well-known ``presidential puzzle." The model can also explain why economic growth has been faster under Democratic presidencies. In the data, Democratic voters are more risk-averse and risk aversion declines during Democratic presidencies. Public workers vote Democrat while entrepreneurs vote Republican, as the model predicts.

Keywords: political cycles, risk aversion, presidential puzzle

JEL Classification: G12, G18, D72, P16