Political Sentiment and Predictable Returns

Abstract

This study shows that shifts in political climate influence stock prices. As the party in power changes, there are systematic changes in the industry-level composition of investor portfolios, which weaken arbitrage forces and generate predictable patterns in industry returns. A trading strategy that attempts to exploit demand-based return predictability generates an annualized risk-adjusted performance of 6% during the 1939 to 2011 period. This evidence of predictability spans 17% − 27% of the market and is stronger during periods of political transition. Our demand-based predictability pattern is distinct from cash flow-based predictability identified in the recent literature. Received November 15, 2013; accepted April 5, 2016 by Editor Andrew Karolyi.