How Uncertainty About Government Policy Affects Stock Prices

Both investors and the financial media spend much of their time and efforts trying to determine what (if any) changes there will be in government policies and how the changes will impact stock prices. This focus increases during periods of financial crises. The questions for investors and policy makers are:

What impact will uncertainty about government policies have on stocks prices?
What impact will the actual announcements have?

In their paper "Uncertainty About Government Policy and Stock Prices," Lubos Pastor and Pietro Veronesi considered two types of uncertainty:

Policy uncertainty relates to the uncertain impact of a given government policy on the proï¬?tability of the private sector.
Political uncertainty captures the private sector's uncertainty about whether current policy will change.

They found that both types of uncertainty affect stock prices in important ways. The following is a summary of their findings:

The government tends to change policy after performance downturns in the private sector.
Positive announcement returns are typically small, because they tend to occur in states of the world in which the policy change is largely anticipated by investors.
Negative announcement returns tend to be larger, because they occur when the announcement of a policy change contains a bigger element of surprise.
On average stock prices fall at the announcements of policy changes, and the distribution is left-skewed.
The reactions are weak if the change is anticipated, but they can be strong if the markets are caught by surprise. An example would be our government allowing Lehman Brothers to fail, which was perceived by many as signaling a shift in the government's implicit too-big-to-fail policy).
The price fall is expected to be large if uncertainty about government policy is large.
Policy changes increase volatility, risk premia and correlations among stocks.

The bottom line is that the expected announcement return is more negative when there's more uncertainty about government policy. When policy uncertainty is larger, so is the risk associated with a new policy, and so is the discount rate effect that pushes stock prices down when the new policy is announced. When political uncertainty is larger, so is the element of surprise in the announcement of a policy change.

The implication for government policy makers is obvious -- minimize uncertainty about policy. But what, if any, conclusions should you draw in terms of investment policy? The answer should be "None." As the authors found, if a change in policy is predictable, the market has already anticipated the change and incorporated its expected impact into current prices. If the change isn't predictable, the market has also already incorporated the uncertainty into current prices (by raising the discount rate) as well as its best guess on what will happen. Thus, unless your crystal ball is clearer than the collective wisdom of the market, acting on your forecast is likely to prove counterproductive since the evidence demonstrates that there are no expert forecasters.

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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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