The Government Legislative Index and Stock Market Outcomes

Abstract

We compose a Government Certainty Index (GCX), which measures a government’s ability to execute its own policy; encompass president seniority, political capital, and calculus. We show that GCX co-moves positively with stock market performance and negatively (mostly) with stock market volatility (for high GCX). The intuition of our finding is driven from the asset pricing behavioral and risk prospective: stronger government reflects consensus of the people; thus investors overreact to strong leadership and prices go up (return); and a stronger government provides clarity and less uncertainty (risk). We find that the effect of GCX varies across sectors and deciles, and on average, GCX is higher during a second-term presidency and for Democratic presidents by 6.7%, which sheds light on understanding the presidential puzzle. A trading strategy that exploits the GCX demand-based return predictability generates an annualized risk-adjusted performance of 4.8%. Altogether, GCX enhances our understanding of overall uncertainty and a valuable predictor for the financial market.