Political Cycles and Stock Returns. Pietro Veronesi

Political Cycles and Stock Returns Ľuboš Pástor and Pietro Veronesi University of Chicago, National Bank of Slovakia, NBER, CEPR University of Chicago, NBER, CEPR

Average Excess Stock Market Returns 30 20 10 % Per Year 0-10 -20-30 Democratic Presidents Republican Presidents 1927 1935 1944 1953 1962 1971 1980 1989 1998 2007 2015

Average Excess Stock Market Returns, % Per Year Democrat Republican Difference 1927:01 2015:12 10.69-0.21 10.90 (4.17) (-0.07) (2.73)

Average Excess Stock Market Returns, % Per Year Democrat Republican Difference 1927:01 2015:12 10.69-0.21 10.90 (4.17) (-0.07) (2.73) 1927:01 1971:06 10.80-0.20 11.00 (2.83) (-0.03) (1.58) 1971:07 2015:12 10.52-0.22 10.74 (3.46) (-0.06) (2.24) 1927:01 1956:08 12.58-1.89 14.46 (2.51) (-0.20) (1.37) 1956:09 1986:04 5.94 1.38 4.57 (1.62) (0.37) (0.85) 1986:05 2015:12 11.99-0.99 12.98 (3.49) (-0.21) (2.17)

Sample period: 1927-1998

Average Excess Stock Market Returns, % Per Year Democrat Republican Difference 1927:01 1998:12 10.52 1.15 9.38 (3.54) (0.32) (2.05)

Average Excess Stock Market Returns, % Per Year Democrat Republican Difference 1927:01 1998:12 10.52 1.15 9.38 (3.54) (0.32) (2.05) 1999:01 2015:12 11.37-6.02 17.39 (2.48) (-0.91) (2.14)

Our Story

Our Story Election outcomes are endogenous Democrats get elected when expected returns are high Republicans get elected when expected returns are low

Our Story Election outcomes are endogenous Democrats get elected when expected returns are high Republicans get elected when expected returns are low Time-varying risk aversion Risk aversion high Elect Democrats (D) Risk aversion low Elect Republicans (R) So risk premia are high under D, low under R Risk aversion Less willingness to take business risk, More demand for a social safety net Elect party promising more redistribution (D)

1 2 3 4 5 6 7 8 9 : ; 2 < = 8 > 9?! " # $! % & ' ( ) * ' + # +, -. / + 0 +

N O P Q R S T U V W X O Y Z U [ V \ @ A B C D E F G B E H I J J K L C B M A B

Our Contribution Develop a new model of political cycles Agents with heterogeneous skill, time-varying risk aversion Agents choose occupations, vote in elections First model that generates the presidential puzzle Model also predicts higher GDP growth under Democrats Under additional assumptions

Literature Presidential puzzle Santa-Clara and Valkanov (2003) Niederhoffer, Gibbs, and Bullock (1970), Huang (1985), Hensel and Ziemba (1995), Powell, Shi, Smith, and Whaley (2007), etc. Political cycles Opportunistic (Nordhaus, 1975) Partisan (Hibbs, 1977, 1987, Alesina 1987, etc.)

Average Change in the Federal Tax/GDP Ratio, % Per Year Democrat Republican Difference 1929:01 2015:12 0.44-0.30 0.74 (2.48) (-1.94) (3.15)

Average Change in the Federal Tax/GDP Ratio, % Per Year Democrat Republican Difference 1929:01 2015:12 0.44-0.30 0.74 (2.48) (-1.94) (3.15) 1929:01 1972:06 0.47-0.26 0.73 (1.60) (-1.33) (2.07) 1972:07 2015:12 0.41-0.32 0.73 (3.92) (-1.47) (3.04) 1929:01 1957:12 0.61-0.17 0.78 (1.51) (-0.61) (1.59) 1958:01 1986:12 0.17-0.27 0.44 (1.11) (-1.11) (1.52) 1987:01 2015:12 0.44-0.36 0.81 (3.64) (-1.35) (2.76)

Differences from Traditional Partisan Models Interpretation of Democrats and Republicans Traditional: Democrats: Prioritize growth Republicans: Prioritize inflation This paper: Democrats: Big government, high taxes Republicans: Small government, low taxes Party policies taken as given Preferences over consumption, not policies Asset pricing implications Agents make not only electoral but also occupational choices Median voter s identity changes over time

Model Overview Beginning of period t: Risk aversion γ t drawn Agents born, choose Entrepreneurs start firms, invest, trade { Entrepreneur Occupation: Government worker { High-tax Party: Low-tax End of period t: Firms produce output Y i,t+1, pay taxes and dividends Agents consume C i,t+1, die

Model Continuum of agents i [0, 1], all endowed with one unit of capital Preferences: U t ( Ci,t+1 ) = C 1 γ t i,t+1 1 γ t Agents are heterogeneous in entrepreneurial skill µ i : ( ) µ i N 0,σµ 2 Agents who become entrepreneurs produce output Y i,t+1 = e µ i +ε t+1 +ε i,t+1 G t G t is government s contribution (positive, bounded) ε t+1, ε i,t+1 i.i.d. normal, E(e ε t+1) = E(e ε i,t+1) = 1

h i j k l m n o p q r s t u l v w x y z { ] ^ _ ` a b c d d e f g

Model (cont d) Each agent chooses one of two occupations: 1. Entrepreneurs: invest, take firm-specific risk Start a firm producing dividend Y i,t+1 (1 τ t ) Can sell fraction 1 θ of the firm to other entrepreneurs 2. Government workers: support entrepreneurs Live off taxes paid by entrepreneurs Cannot sell claims to their future income Each agent votes for one of two political parties: 1. H: Tax rate τ H 2. L: Tax rate τ L, such that τ L < τ H Tax revenue distributed equally among government workers Election decided by the median voter

Solution I t : set of agents who decide to become entrepreneurs m (I t ): mass of entrepreneurs (E) 1 m (I t ): mass of government workers (G) I t is determined in equilibrium as I t = { i : E t [ U ( Ci,t+1 ) i = E ] Et [ U ( Ci,t+1 ) i = G ]} We solve for Nash equilibrium 1. Electoral choice, taking occupational choice as given 2. Occupational choice, taking electoral choice as given

Electoral Choice Proposition: All entrepreneurs vote for party L. All government workers vote for party H. Corollary: Party L wins the election iff m t > 0.5.

Occupational Choice Proposition: Assume that party k {H,L} is in power. Agent i becomes an entrepreneur iff µ i > µ k t where µ k t is given in the paper.

Government workers Entrepreneurs k _ i

Comparative Statics The equilibrium mass of entrepreneurs, m k t, is decreasing in Tax rate τ k Risk aversion γ t Idiosyncratic volatility σ 1 Degree of market incompleteness θ

G E L _ i

G E H _ i

Always G E under L G under H Always E L _ H _ i

Equilibrium Proposition: There exist two thresholds γ < γ such that 1. For γ t > γ, there is a unique equilibrium: m t < 1 2 2. For γ t < γ, there is a unique equilibrium: m t > 1 2 and party H wins and party L wins 3. For γ < γ t < γ, there are two equilibria: (a) If agents believe party H will win, then m t < 1 and H wins 2 (b) If agents believe party L will win, then m t > 1 and L wins 2

Comparative Statics The equilibrium mass of entrepreneurs, m k t, is decreasing in Tax rate τ k Risk aversion γ t Idiosyncratic volatility σ 1 Degree of market incompleteness θ

Skill ( i ) k _ Risk Aversion ( t )

Skill ( i ) H _ L _ Risk Aversion ( t )

Skill ( i ) H _ L Risk Aversion ( t )

Skill ( i ) H _ L _ Risk Aversion ( t )

Skill ( i ) Unique eq. L wins Two eq. possible Unique eq. H wins H _ L _ Risk Aversion ( t )

Stock Prices Closed-form solution for market value of firm i: M i,t = (1 τ t ) e µ i γ t σ 2 G t Expected stock market return: E t (R t+1 ) = γ t σ 2

Implications for Returns Proposition: If γ t fluctuates sufficiently so that at least one of γ t < γ and γ t > γ occurs with nonzero probability, then ( E R t+1 τ t = τ H) > E (R t+1 τ t = τ L) Recall the three scenarios: 1. γ t > γ Equilibrium H 2. γ t < γ Equilibrium L 3. γ < γ t < γ Two equilibria, H/L ER L < γσ 2 < ER H/L < γσ 2 < ER H

Implications for Growth Economic growth = Y t+1 1 = Y t+1 = E (e µ i i I) m t G t e ε t+1 Proposition: Private sector productivity is higher under H: ( E e µ i i I,τ = τ H) > E (e µ i i I,τ = τ L)

G E L _ i

G E H _ i

Implications for Growth Economic growth = Y t+1 1 = Y t+1 = E (e µ i i I) m t G t e ε t+1 Proposition: Private sector productivity is higher under H: ( E e µ i i I,τ = τ H) > E (e µ i i I,τ = τ L) Add two assumptions: G t = (1 m t ) e g m H + m L = 1 (A1) (A2) Proposition: Expected growth is higher under party H: ( E Y t+1 τ t = τ H) > E (Y t+1 τ t = τ L)

Average Real GDP Growth 15 10 % Per Year 5 0-5 Democratic Presidents Republican Presidents -10 1927 1935 1944 1953 1962 1971 1980 1989 1998 2007 2015

Average GDP Growth, % Per Year Democrat Republican Difference 1930:01 2015:12 4.86 1.70 3.16 (4.87) (1.96) (2.40)

Average GDP Growth, % Per Year Democrat Republican Difference 1930:01 2015:12 4.86 1.70 3.16 (4.87) (1.96) (2.40) 1930:01 1972:12 6.11 0.36 5.75 (4.06) (0.18) (2.33) 1973:01 2015:12 3.02 2.54 0.47 (7.12) (4.98) (0.76) 1930:01 1958:08 6.46-1.86 8.31 (3.07) (-0.63) (2.33) 1958:09 1987:04 4.64 3.16 1.47 (7.09) (4.40) (1.50) 1987:05 2015:12 2.91 2.21 0.70 (7.59) (4.32) (1.27)

Endogenous Risk Aversion Link γ t to the state of the economy: γ t = γ(y t ), where γ (Y t ) < 0 Risk aversion when economy weak, when strong Political cycles arise naturally: ˆ ~ ƒ Š } ~ ƒ ~ } Š Œ ƒ Š } ~ Œ ƒ Ž Š } ~ } ~ ƒ ~ } } Š ƒ Š

Endogenous Risk Aversion (cont d) Assume γ t = { γ H, where γ H > γ, for y t < y γ L, where γ L < γ, for y t > y Define λ H,L Prob (L wins election H is in power) λ L,H Prob (H wins election L is in power) Proposition: Under (A1) and (A2), ( λ H,L = λ L,H E [yt+1 H] E [y = Φ t+1 L] 2 ; 0,σ 2 ) > 1 2

Example τ H = 34%, τ L = 32% σ µ = 10%, σ = 20%, σ 1 = 50%, θ = 0.6, g = 0.2 γ = 2.7, γ = 4.2 γ t = γ H = 5 for y t < y Eq.: H Prob = 1 3 γ M = 3 for y y t y Eq.: H/L Prob = 1 3 γ L = 1 for y t > y Eq.: L Prob = 1 3 We obtain τ t E(R t+1 ) E(Y t+1 ) m t Party H in power 34% 15.4% 3.8% 48.1% Party L in power 32% 4.7% 3.6% 54.1%

Simulated Market Returns 30 20 10 % Per Year 0-10 -20-30 H-Government L-Government 0 10 20 30 40 50 60 70 80 90 Years

Conclusions Develop a new model of political cycles Election outcomes are driven by time-varying risk aversion One or two equilibria, depending on risk aversion Median voter s identity changes over time Political cycles arise naturally First model that generates the presidential puzzle Model also predicts higher GDP growth under Democrats Under additional assumptions

Announcement Effects Mixed equilibrium for γ L < γ < γ M < γ < γ H Proposition: There exists γ M [ γ,γ ] for which there is a mixed equilibrium with m t = 2 1. Median voter is indifferent between H and L, choosing one with probability 1 2. (a) Stock market reactions to election outcomes: AR H t < 0 < AR L t (b) The risk premium for electoral uncertainty is positive Example: γ M = 3.38 AR H t = 1.42%, AR L t = 1.57%

Additional Empirical Results

Average Stock Market Returns, % Per Year Democrat Republican Difference Year 1 in office 21.75-15.13 36.88 (2.03) (-1.94) (2.70) Years 1 and 2 in office 11.47-4.08 15.55 (1.73) (-0.66) (1.56) Years 1, 2, and 3 in office 15.00 2.57 12.43 (3.11) (0.56) (1.67) Full term 10.69-0.21 10.90 (4.17) (-0.07) (2.73)

Transition from Republicans to Democrats Transition from Democrats to Republicans Panel A. Lag of 3 months Stock return -13.66-0.32 (-1.33) (-0.02) GDP growth -0.17-0.01 (-2.38) (-0.12) Market variance 10.66-10.00 (3.38) (-0.43) Panel B. Lag of 6 months Stock return -16.19 10.94 (-1.03) (0.48) GDP growth -0.17-0.04 (-2.26) (-0.38) Market variance 12.35-11.39 (2.57) (-0.47)

Transition from Republicans to Democrats Transition from Democrats to Republicans Panel C. Lag of 12 months Stock return -36.44 11.99 (-2.09) (0.39) GDP growth -0.14-0.02 (-1.80) (-0.22) Market variance 13.58-6.67 (2.02) (-0.34) Panel D. Lag of 36 months Stock return -66.33 60.22 (-2.46) (0.93) GDP growth -0.17 0.07 (-1.95) (0.66) Market variance 12.59-20.56 (1.15) (-0.65)