How government policy decisions move stocks

(MoneyWatch) With the elections dominating the headlines, it's a good time to discuss how government policy decisions affect stock prices. For those hoping to hear that specific policies will cause the market to jump, sorry to disappoint you. It's not so much the actual announcement that affects stocks, but whether the markets were expecting it.

Government policies shape the environment in which businesses operate in many ways -- taxes, subsidies, regulations, labor laws, environmental policies, trade policies, and so on. Rule changes can bring reactions in financial markets. If the change is anticipated, the reactions are likely to be weak. However, if the change is unanticipated, the reaction can be large, as it was when Lehman Brothers was allowed to fail -- the government signaled a shift in its perceived policy of too-big-to-fail and the S&P 500 Index fell almost 5 percent on Sept. 15, 2008.

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The focus of the study "Uncertainty About Government Policy and Stock Prices" is on the role of uncertainty about government policy because uncertainty generally reduces investment when it's at least partially irreversible. The authors considered two types of uncertainty:

• Policy uncertainty, which is the uncertain impact of a given government policy on the profitability of the private sector.
• Political uncertainty, which captures the private sector's uncertainty whether the current government policy will change.

In other words, there's uncertainty about what the government is going to do, as well as what the effect of its action is going to be. The base assumption is that the government's economic motive is benevolent -- changes should be made for the better. (Please save all jokes for the water cooler.) The following is a summary of the study's findings:

• Both types of uncertainty affect stock prices in important ways.
• Any policy change that should lift stock prices is mostly expected, so that much of its effect is priced in before the announcement.
• Negative announcement returns tend to have a bigger impact on stocks because they occur when the announcement of a policy change contains a bigger element of surprise.
• The bulk of policy announcements are positive and already anticipated. That means there are more positive results. Negative results, however, are typically much larger than positive results. In fact, gains of more than 2 percent are rarer than losses of 10 percent.
• Stock market returns at the announcements of policy changes should be negative unless the policy being replaced is perceived as sufficiently harmful to profitability.

• The return in response to a policy announcement is more negative when there is 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.