Is the strong gain in the U.S. stock market following the November 2016 national election rational or irrational? In their February 2018 paper “Why Has the Stock Market Risen So Much Since the US Presidential Election?”, flagged by a subscriber, Olivier Blanchard, Christopher Collins, Mohammad Jahan-Parvar, Thomas Pellet and Beth Anne Wilson examine sources of the 25% U.S. stock market advance during November 2016 through December 2017. They consider four sources: (1) increases in actual and expected dividends; (2) perceived probability and the fact of a reduction in the corporate tax rate; (3) decrease in the U.S. equity risk premium; and, (4) an irrational price bubble. For the impact of the tax rate reduction on corporate income, they use estimates from the Joint Congressional Committee on Taxation. For the relationship between dividends and the equity risk premium, they assume the difference between dividend-price ratio and risk-free rate equals equity risk premium minus expected dividend growth rate. They also consider the effect of U.S. and European economic policy uncertainty on the U.S. equity risk premium. Using the specified data during November 2016 (and earlier for validation) through December 2017, they find that:
- Regarding dividends in isolation:
- Actual dividends increase by 9% since the election.
- Ignoring tax cut effects, expected dividend growth rate does not change.
- Reduction in the corporate tax rate:
- Expectation of the reduction (as measured by odds on the betting site PredictIt) is high during the period of interest, with a large increase near the end of 2017.
- Econometric estimates suggest the tax reduction contributes in the range 2% to 6% to stock market valuation.
- The remainder of the 25% advance is reasonably attributable to a decrease of less than 1% in the equity risk premium, wherein lower economic policy uncertainty in the rest of the world (particularly Europe) more than offsets higher U.S. policy uncertainty.
In summary, rough analyses suggests that the strong post-November 2016 advance in the U.S. stock market may be largely justified (rational) and therefore could stick.
Cautions regarding findings include:
- Analyses are retrospective, with no evidence of exploitability during the test period.
- Methods used may not be materially and reliably useful for prediction of intermediate-term (one year) stock market movements because input variables are not usefully predictable. For example, expectations of a reduction in corporate tax rate range from less than 20% to 100% during the test period (and are weakest just before legislative success at the end of the period).
- Measuring economic policy uncertainty is subjective.
