A striking feature of the U.S. stock market is that it persistently does better under Democratic presidents than Republican ones. In a 2003 paper, Pedro Santa-Clara and Rossen Valkanov found that regardless of how they sliced the data, returns were substantially better for Democrats. Since then, with the poor returns under President George W. Bush and the strong returns under President Barack Obama, the effect has only become stronger.
Messrs. Santa-Clara and Valkanov couldn’t come up with a satisfactory explanation for the presidential puzzle. But in new research, University of Chicago Booth School of Business economists Lubos Pastor and Pietro Veronesi think they have come up with the answer.
The two economists created a model where people have a choice between being entrepreneurs and working for the government, and of voting for a political party that favors lower taxes or higher taxes. When risk aversion is low, more people want to be entrepreneurs and to vote for the low-tax party. When risk aversion is high, the opposite is true.
It is a highly simplified version of U.S. politics and economics. But the implications for stock prices are interesting. The low-tax party gets elected when risk aversion is low, and then if risk aversion merely returns to the mean, stocks suffer. For the high-tax party, the opposite is true.
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