The Impact of Political Variables on Stock Returns and Investor Sentiment

(ProQuest: . denotes formulae omitted.)L INTRODUCTIONSince the start of the Great Recession, various groups (e.g., Main Street and Wall Street) have relentlessly pressed politicians to "jumpstart the economy" or to "get the economy out of life support. " As a result, both the legislative and executive branches of government signed into law economic policies meant to reactivate the economy (e.g., The Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009, and the Dodd-Frank Wall Street Reform and Consumer Protection Act). However, the slow recovery of the U.S. economy has many inside and outside of Washington D.C. wondering if politicians have the power to help ease credit conditions, reduce unemployment, boost investor confidence, and increase asset values. The uncertainty on whether the President and the Democratic party can revive the economy has turned political harmony into political gridlock1 (in 2010 Republicans won control of the House of Representatives), which makes it harder for the President and his party to pass new landmark economic policies. For example, President Obama's American Jobs Act, which proposed to lower the unemployment rate, stalled in the U.S. Senate in October of 2011 largely due to Republican skepticism of the President's economic policies. As a further example, in the summer of 2011, a major credit rating agency (SP Santa-Clara and Valkanov, 2003; Chen et al., 2008; and Ramchander et al., 2009), which only evaluate the impact of political variables on stock market returns and volatility, we also examine the impact of these variables on investor sentiment. To the best of our knowledge there is only one other paper which examines the possible link between political variables and investor sentiment (Kraussl et al., 2009). Their paper, however, uses annual data and utilizes investor sentiment as an additional control variable. It also regresses investor sentiment on the presidential cycle dummies, without accounting for a Democratic or Republican controlled White House.Prior literature finds that stock returns are influenced by investor sentiment (Leroy and Porter, 1981; Shiller, 1981; De Bondt and Thaler, 1985; Lee et al., 1991; Lee et al., 2002; Lee et al., 1991; Brown and Cliff, 2005; Baker and Wurgler, 2007; Ho and Hung, 2009; and Baker et al., 2012). Therefore, it is reasonable to assume that if stock returns are influence by political variables then investor sentiment might also be influenced by political variables.This study contributes to the literature in the following distinct ways. First, we examine whether political variables impact investor sentiment. Second, we assess the impact of political variables on the covariance between the returns of the market portfolio and investor sentiment. Furthermore, we investigate how the covariance between investor sentiment and the returns on ten portfolios constructed by size, and ten portfolios constructed by book-to-market is influenced by political variables; we use these portfolios to test for any differential effects due market capitalization and book-to-market differences. …