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“It’s the P/E, Stupid!”

| | Posted in: Fundamental Valuation, Political Indicators

Is there a relationship between investor risk-aversion, as indicated by the aggregate U.S. stock market price-earnings ratio (P/E), and level of public satisfaction with the performance of the President? In their December 2008 paper entitled “Speculating on Presidential Success: Exploring the Link between the Price-Earnings Ratio and Approval Ratings”, Tomasz Wisniewski, Geoffrey Lightfoot and Simon Lilley examine the relationship between aggregate stock market P/E and the surveyed level of public approval of the current President. Using quarterly P/E for the S&P Composite Stock Price Index derived from Robert Shiller’s long-run dataset and Gallup presidential approval survey data from the beginning of 1950 through the third quarter of 2007 (231 observations), they conclude that:

  • There is a significant relationship between aggregate U.S. stock market P/E and presidential approval rating. The R-squared statistic for a simple regression indicates that changes in P/E explain about 14% of the variation in presidential approval.
  • A one-point increase in P/E relates to a contemporaneous (long-term) increase in presidential approval rating of 0.62% (1.9%).
  • P/E has greater explanatory power for presidential approval rating than post-election honeymoon, scandals, military activity, unemployment and inflation.

This connection between aggregate valuation and political approval perhaps implicitly quantifies an incentive for politicians to foster equity investment bubbles, with the hope that no bubble bursts during their incumbencies. In other words, the direction of causality is not obvious.

In summary, stock market P/E and presidential approval rating are significantly intertwined.

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