J Econ Finan (2012) 36:106122

DOI 10.1007/s12197-009-9116-0

Speculating on presidential success: exploring the link

between the priceearnings ratio and approval ratings
Tomasz Piotr Wisniewski & Geoffrey Lightfoot &
Simon Lilley

Published online: 27 November 2009

# Springer Science+Business Media, LLC 2009

Abstract Stock markets and politics are enduring staples of dinner party
conversations but surprisingly little is known about the interaction between the
two. Here we present evidence for a robust relationship between a key financial
measurethe aggregate PriceEarnings ratioand surveyed approval of the
incumbent president. We argue, following the finance literature, that the price
earnings ratio is a composite measure of investors hopes and fears. The partially
prospective nature of this ratio enables us to shed new light upon the controversy
surrounding how the electorate attends to economic circumstances in judging its
presidents.
Keywords Political Economy . PriceEarnings Ratio . Presidential Approval

Simon Lilley would like to acknowledge the support of the University of Leicesters sabbatical scheme.
We are also grateful to Katrin Gottschalk, Emmanuel Haven, Barry OGrady, Emmanuel Pikoulakis,
participants at the 16th Annual Conference of the Multinational Finance Society, the journal editor and
anonymous reviewers for their helpful comments and suggestions. The authors retain the responsibility for
all remaining errors.
T. P. Wisniewski
School of Management, University of Leicester, Ken Edwards Building, University Road,
Leicester LE1 7RH, UK
e-mail: t.wisniewski@le.ac.uk
G. Lightfoot (*) : S. Lilley
School of Management & Centre for Philosophy and Political Economy, University of Leicester,
Ken Edwards Building, University Road, Leicester LE1 7RH, UK
e-mail: g.lightfoot@le.ac.uk
S. Lilley
e-mail: s.lilley@le.ac.uk

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JEL Classification G10 . G14 . P16

1 Introduction
Stock markets and politics are enduring staples of dinner-party conversations, but
surprisingly little is known about the interaction between the two. The studies that
have been written so far have tended to be from the perspective of a trader and
within these two distinct streams of thought can be identified. The first concentrates
on the political business cycle, which was introduced by Nordhaus (1975: 187), who
suggested that within an incumbents term in office there is a predictable pattern of
policy, starting with relative austerity in early years and ending with the potlatch
right before elections. Herbst and Slinkman (1984) and Booth and Booth (2003)
developed the market ramifications of this insight to demonstrate the existence of a
48 month cycle within stock movements. The second theme examines the
profitability of different investment strategies under Democratic and Republican
administrations. Notable here are Hensel and Ziembas (1995) intriguing conclusion
that a politically correct strategy1 would outperform a range of other investment
approaches and Santa-Clara and Valkanovs (2003) finding that returns are robustly
higher under the Democrats.2 These studies, then, are primarily oriented to
informing trading practice. In this paper, we change perspective to examine how
policy makers might derive information from financial market performanceor
more precisely, expectations of suchparticularly with regard to the ways in which
such expectations relate to approval of an incumbent president.
Exploration of the relationship between electoral preferences and a variety of nonfinancial economic indicators has considerable history (Lewis-Beck and Stegmaier
2000). Studies have integrated a range of different measures of economic well-being,
some utilizing directly observable macroeconomic variables such as the unemployment rate, the rate of inflation or both (e.g. Kenski 1977; Kernell 1978; Golden and
Poterba 1980; Ostrom and Simon 1985), whilst others draw on opinion surveys,
such as the Michigan Survey of Consumer Attitudes and Behavior (e.g. MacKuen et
al. 1992; Erikson et al. 2000). The latter two studies cited are perhaps the most
controversial within this tradition. In attempting to establish whether the electorate
tends to look back at past or forward to future predicted economic performance the
authors mobilize a striking metaphorical illumination, the contrast between Peasants
and Bankers. Peasants are apparently those who are retrospective in their judgmental
orientation and focused parochially upon the reflection of change in their own
pocketbooks, whilst Bankers are seen to be prospective and broader in their
orientation, looking sociotropically at the economy as a whole.
The controversy turns on a number of points. Most immediately there is the
question of whether looking forward or looking back predominates in judging of the
president. The latter position is most vividly captured by Keys (1964: 568)
1
A politically correct investment strategy is one that favours small cap stocks during Democratic
presidencies and large cap stocks or government bonds during those in which the incumbent is
Republican.
2
Several recent papers have questioned the existence and strength of these stock market anomalies (see
for example Jones and Banning 2009; Bialkowski et al. 2007 and Powell et al. 2007).

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conception of the electorate as a rational god of vengeance and reward, whilst the
former is most clearly captured in MacKuen et al.s (1992) original article on the
subject. The controversy seems far from settled in any of its dimensions. As LewisBeck and Stegmaier (2000: 188) pithily note: leading scholars, looking at
essentially the same data, and following model specifications that are conceptually
similar, arrive at estimates that yield opposite conclusions.
Attention has since focused on both more nuanced attempts to grasp the extent of
the two possible orientations and, more intriguingly, on the methodological
difficulties of successfully separating them, given the data available (see, for
example, Clarke and Stewart 1994; Norpoth 1996). Vital here has been the issue of
the possible multicollinearity of the prospective and retrospective perceptions of
economic performance that constitute a central part of the data drawn upon from the
Michigan survey. Measures of economic prospects and retrospections are garnered
from the Michigan survey by a set of questions that ask how the respondent
perceives both her own situation or that of business conditions, both via categorical
judgment (good vs. bad) and in a more relative sense (better vs. worse) over a
number of time periods. The long-term categorical judgment of the economy as a
whole is seen by Erikson et al. (2000: 301) to be the most effective correlate of
approval. However, Lewis-Beck and Stegmaier (2000: 188), following Norpoth
(1996), suggest that in time series derived from the data drawn from the Michigan
survey multicollinearity may be rendering coefficients unstable, subject to serious
change from one specification to the next (see also, Greene 2000: 257).
In this paper, we are uniquely able to shed more light on and develop fruitfully
the Bankers/Peasants distinction for two key reasons. Firstly, only one of our
variablesthe PriceEarnings ratiois (in part at least) prospective in orientation
and it is not highly inter-correlated with our measures of retrospection. And
secondly, this measure of economic expectation is in large part moved by those who
we can assume to be informed and who have financial interest in the accuracy of
their predictions. Specifically, we demonstrate a robust correlative relationship
between the aggregate P/E ratio and Gallup polling presidential approval ratings.
Doing so enables us to draw upon the enhanced informational content seen to derive
from knowledgeable, financially interested participation in a market, as opposed to
mere expression of opinion (see, for example, Arrow et al. 2008). The extent of this
financial interest in the stock market is indexed both by the approximately 18% of
US families who directly hold shares and the more than half of them who are either
direct or indirect shareholders, the latter primarily via their ownership of mutual funds
and/or pension plans (Federal Reserve Board, Survey of Consumer Finances 2007, see
particularly Tables 5 and 6). One could also point to the 850,000 plus individuals
employed in the US securities industry in 2007 (SIFMA 2008:16) and the huge extent
of activity on the market. With several million trades, representing 3.4 billion shares,
executed on a typical single day on the New York Stock Exchange3 alone, an ongoing
incorporation of an expansive range of shifting informed opinion can rapidly take
place. As MacKuen et al. (1996: 795, see also Erikson et al. 2000: 299) point out:
people will process information more slowly than financial markets.
3

Calculated from 2007 data of Historical NYSE Group Volume available at http://www.nyse.com/
financials/1143717022567.html, last accessed 11 December 2008.

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Erikson et al. (2000: 298), in their re-visitation of the Bankers and Peasants
distinction, justify their hypothesis that the electorate can be, and is, informed by
expectations of the future performance of the economy by noting that individual,
economically active, citizens will find it worthwhile to anticipate inflation, interest
rates, and their own income stream. They contend that everyday interaction
facilitates the transfer of information from sophisticated analysts, through the mass
media, and down to the street level and that the consensus street forecast is roughly
the same as the opinion of an average expert (Erikson et al. 2000: 299). Our
approach is in sympathy with this line of reasoning, but rather than trying to discern
the impact of the expert signal on approval via attending to its reflection in
aggregate perceptions on the economy, we prefer to hear it from the horses mouth.
The relationship between approval and one of the likely key objective underpinnings
of that shifting expert signal produced by sophisticated analyststhe Price
Earnings ratiois examined directly. And in doing so, we discover a relationship
that appears to be substantive and robust.
Although clearly there is no complete identity between the two populations of
investors and electors it is reasonable to assume that in coming to their respective
opinions on the state of and prospects for the economy they are mutually influential.
Not only are electors likely to be in part informed about the economy by the ways
in which discussion by and for investors on such takes place. Investors themselves
are likely also to be endlessly trying to ascertain how the wider population will
respond to perceived economic circumstances and prospects, given the extent of
influence of consumer sentiment upon the performance of the economy.
The remainder of the paper is organized as follows. In the next section we
elaborate on our choice of prospective explanatory variable, the P/E ratio. In the
third section we go on to discuss the control variables incorporated into our model,
exploring both their construction and the sources of data from which they derive.
The fourth section presents and discusses our empirical results before we conclude
with an assessment of their possible implications.

2 The priceearnings ratio

The PriceEarnings Ratio is the most popular investment ratio, forming a ubiquitous
benchmark for stock comparison. It divides the companys share price by the
companys annual earnings; in this paper we use the data on composite price from
the Standard and Poors (S&P) Composite Stock Price Index and the corresponding
S&P index of earnings compiled by Robert Shiller. In his seminal book Irrational
Exuberance (2000) Shiller argues that the P/E ratio predicted, among others, the
burst of the Internet bubble and the Great Depression of the 1930s, as well as the
poor performance of the stock market in the first two decades of the twentieth
century and in the late 1960s. He also shows how the PriceEarnings ratio acts as a
predictor of subsequent (long-term) returnsa relationship that he contends holds
for other countries and for individual stocks. (2000: 12) Shiller is working within a
long tradition of research on the PriceEarnings ratio which dates back to Basus
(1977) intriguing paper, which demonstrated that the P/E ratios of stock portfolios
were strong predictors of their future performance.

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The PriceEarnings ratio can be interpreted as a composite measure of investors

hopes and fears, which can also be demonstrated mathematically. To establish this,
we start with the Gordon growth formula for the pricing of equities (or businesses)
(see Gordon 1962) and derive the ratio from it. Thus we commence with:
P0

D0 1 g nE0 1 g

rg
rg

P 0 n 1 g

E0
rg

where P0, D0 and E0 are the current stock price, dividend, and earnings per share,
respectively. r denotes the non-negative discount rate, which increases with the level
of risk, g stands for the future long-term growth rate in dividends and v is the
dividend payout ratio. The Gordon growth model also assumes that r > g.
Taking the derivative with respect to the future growth rate g, it can be shown that:
@ P0 =E0 n 1 r
>0

@g
r  g 2

This shows that as optimism about the future growth rate g increases, the Price
Earnings ratio rises. Further, the differentiation of the ratio with respect to r gives the
following result:
@ P0 =E0 v1 g

< 0
@r
r  g 2

Given that the discount rate r is assumed within financial theory to be a

monotonically increasing function of risk (see, for example, Sharpe 1964; Lintner
1965; Mossin 1966; and Fama and French 1992), one can conclude that the P/E ratio
will decrease as uncertainty about the future grows.
According to the derivations provided above, the P/E ratio can be seen as a gauge
of expectations that incorporates assessments of both future risk and future growth
rates. This has been borne out by empirical research, with various studies
emphasizing growth (see, for example, Zarowin 1990; Ramcharran 2002), risk
(Kane et al. 1996), or both (Nikbakt and Polat 1998; Shamsuddin and Hillier 2004).
These papers use different variable definitions and a range of econometric methods
but still, in general, support the prospective nature of the P/E ratio.
The PriceEarnings ratio is empirically a more stable index of public sentiment
than stock market returns or share price alone. Stock prices, according to Shiller
(1981), appear to be five to thirteen times more volatile than can be explained by
underlying fundamentals; while the movement in returns, according to Cutler et al.
(1989), cannot be fully accounted for in terms of relevant new information. Since the
P/E ratio also has the added advantage of incorporating predictions about future
returns, it avoids many of the pitfalls that come from using other common financial
variables, and we therefore concentrate our analysis on this measure.
The PriceEarnings ratio is published for major listed businesses in the companies
and markets section of most major broadsheet newspapers both in the US and

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around the world.4 It also often forms part of the subject of discussion in articles,
television shows and other media, in which pundits attempt to assess the likely
direction of market movements and indeed that of the economy as a whole. To take a
couple of illustrative examples, in the first two weeks of June 2009 two articles,
entitled This Rally May Need a New Source of Fuel and Developing Markets in
Bloom Again, appeared in The New York Times (Lim 2009; Bajaj and Bradsher, 2009).
Both of them drew at some length on the PriceEarnings ratio, in their discussions of
prospects for the US and so-called developing countries economies, respectively.

3 Data sources and variable construction

In this study we use data from the first quarter of 1950 to the third quarter of 2007,
which translates into 231 observations for each variable. We begin our series in 1950
because the Gallup presidential opinion survey, although it had been running since
the late 1930s, was not conducted sufficiently frequently for quarterly analysis until
then.5 From the beginning of the survey, the Gallup Organization has asked the
question: Do you approve or disapprove of the job [that the current incumbent] is
doing as president? If the interviewee has no opinion, he or she will have to proffer
that response him or herself. In this paper, we define our dependent variable
(Approval) as a percentage of the respondents that express support, and generate an
index through an arithmetic average of all surveys within a given quarter.
PriceEarnings (variable PE_Ratio) is defined as the current price divided by the
previous 12 months earnings. Both the composite stock price data and the
composite earnings series are from Standard and Poors relevant indices. We drew
the data from Professor Shillers archive6 that he explored in his influential books
Market Volatility (1989) and Irrational Exuberance (2000) and has continued to
update and make available to other researchers.
Although the primary objective of the study is to reveal the relationship between
PE_Ratio and Approval, a number of additional variables have been constructed to
act as controls in our regression analyses. Following Frey and Schneider 1978;
Golden and Poterba 1980; Norpoth 1996, and Lewis-Beck and Stegmaier 2000, we
incorporate an indicator variable to capture the erosion of public confidence in
leadership related to major governmental scandals. This takes the value of 1 for the
investigation into corruption in the Bureau of Internal Revenue (Q1 1951Q4 1952),
Watergate (Q2 1973Q2 1974), Iran-contra (Q4 1986Q1 1987) and the Monica
Lewinsky/Zippergate scandal (Q1Q3 1998), but remains at 0 for all other quarters.
The dates for the first are drawn from Grossman (2003: 206), timings for Watergate
and Iran-contra are from Norpoth (1996) and Zippergate is taken to run from the
exposure of Clintons affair with Lewinsky by the Drudge Report in January 1998
until the delivery of Kenneth Starrs Report in September 1998.
4
For example, in the UK such appears in, inter alia, The Times, The Financial Times, The Daily
Telegraph, The Guardian, and The Daily Mail.
5
Quarterly data is available in consistent form from around 1950. It is not until much later in the series
that consistent monthly data becomes available.
6
The complete data series, along with further definitions, is available at Professor Shillers webpage:
http://www.econ.yale.edu/~shiller/data.htm.

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A further considerationparticularly visible at the time of writing as we live

through the tail-end of the George W. Bush presidencyis that of military
engagements. From an econometric standpoint, construction of this variable is
fraught with difficulties. As Kernell (1978: 509) points out, a dichotomous index
(which only measures the presence or absence of war) fails to record the quantitative
and qualitative differences within particular conflicts. Additionally, since the last
officially declared war by the United StatesWWIIthere have been six
engagements authorized by Congress and a total of 155 instances of use of United
States Armed Forces abroad up to the end of our sample period (Grimmett 2008).
Defining a simple variable from this history is a thorny problem indeed. Instead, in
order to recognize the heterogeneous magnitudes of conflicts, we construct a
variable based upon military expenditure, similar to that deployed by Monroe
(1978). More specifically, this variable measures the change in the national defense
outlays to GDP ratio. Quarterly observations were extrapolated from annual data sourced
from the Historical Tables: The Budget of the United States Government (2008).
There is also the honeymoon effect. As Norpoth (1996: 782) comments, a new
president comes to office with an approval rating substantially above the final rating
of his predecessor, support that steadily declines over subsequent years. There are
two competing explanations for this phenomenon. The first suggests that the drop
comes from the collapse of a coalition of minorities (Mueller 1970: 20) where
policy decisions succeed in alienating parts of the broad coalition enrolled in the
presidential campaign. The second argues that simplistic campaign pledges lead to
exuberant expectations within an ill-informed and unattached portion of the
electorate that inexorably will lead to disillusionment when confronted by harsh
post-election reality (Stimson 1976). Our variable (Inauguration) takes the value of
one in the quarter in which the president takes office, similar to that utilized by
Norpoth (1996) and Lewis-Beck and Stegmaier (2000). Since our empirical model is
dynamic in that it includes an autoregressive term, the diminishing impact of the
inauguration is also registered in subsequent quarters.
The importance of macro-economic effects has been consistently highlighted by
research in this area (see, for example, Kenski 1977; Kernell 1978; Frey and
Schneider 1978; Golden and Poterba 1980; and Hibbs et al. 1982). In sympathy with
this tradition, we incorporate a variable capturing both unemployment and inflation
rates. Specifically we produce a Discomfort_Index by summing these two variables,
using the seasonally-adjusted civilian unemployment rate for persons 16 years of age
and older and the quarterly percentage increase in the seasonally-adjusted Consumer
Price Index for all urban consumers (all items).7 Both sets of data are from the
Federal Reserve Economic Data (FRED) database.
Of course, our model is not seeking to imply that external factors alone can
determine presidential approval. The president, as a personor more precisely, how
the public views the president as a personis undoubtedly important. Intelligence,
rhetorical skill, personal authority and charisma can all shape how people regard the
president. Thus, in order to capture within our regression some of these time7
We are grateful to one of the anonymous reviewers of this paper for suggesting this approach which
delivers a superior specification to that we had originally employed by treating the two contributors to the
Discomfort_Index separately.

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invariant personality traits and characteristics, we include a set of simple

dichotomous variablesone for each president.
One of our empirical specifications addresses possible endogeneity by instrumenting the key regressor, namely the PriceEarnings ratio. In the selection of the
instruments we are guided by the theoretical predictions drawn from our transformation of the Gordon growth formula discussed above and shown in Eq. 2. Values for the
dividend payout ratio are taken from Professor Schillers archive, and labelled Payout.
On the other hand, future expectations of long-term growth rate are captured by proxy
since such expectations are not directly observable. In defining this proxy, we follow
Shamsuddin and Hillier (2004) and adopt a measure of the rate of growth of GDP.
Specifically, we utilize the real seasonally-adjusted figure from the FRED database,
and term it GDP_Growth. The discount rate is dependent upon risk, which is
measured here by the standard deviation of daily returns on the Standard and Poors
Index within a given quarter. We render this in percentage terms, and denote it as Risk.

4 Empirical findings
For ease of understanding we separate description of our empirical findings into four
separate sections, each of which employs a different methodology. In turn we discuss
the determinants of presidential approval, specification in first differences, two-stage
least squares estimation, and, finally, a vector autoregressive model.
4.1 Determinants of presidential approval
Table 1 presents our findings in the form of several regression results. In Eq. 1 the
presidential approval rating derived from Gallup is linked directly to the P/E ratio via
the Ordinary Least Squares method, without addition of any of the control variables
described in the previous section. The coefficient of determination here reveals that
approximately 14% of variation in presidential approval is explicable by P/E ratio
alone. The very high t-statistic indicates that we can have considerable confidence in
the significance of the relationship. Nevertheless potential modeling issues are
apparent with the specification employed here. First, this regression is likely to suffer
from omitted variable bias, there being, as we note above, many other possible
influences on popularity. Second, additional analysis indicated that the residuals
from the regression are highly autocorrelated and heteroscedastic.
We sought to remedy all of these problems in Eq. 2. Here, following the similar
approach adopted by MacKuen et al. (1992: see particularly 602), we include a
lagged dependent variable as a regressor to mitigate residual autocorrelation. We also
added in the majority of the controls described in the section above. Furthermore, we
assumed that the residuals follow a Generalised Autoregressive Conditional
Heteroscedasticity (GARCH) process8 to deal with the possible inefficiency of the
regression estimates. This class of models takes account of the fact that large errors
tend to cluster in time, and we utilize the Maximum Likelihood method to estimate
8

A simple introduction to GARCH models can be found in Johnston and DiNardo (1997). For those
seeking a more in depth treatment, we would recommend Greene (2000).

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Table 1 Empirical determinants of presidential approval

Variable

Equation 1

Equation 2

Coefficient

t-Statistic

Intercept

42.8000a

20.6565

PE_Ratio

0.7084a

6.1087

Scandals
Military
Inauguration
Discomfort_Index

Coefficient

z-Statistic

0.6064a

8.3519

5.8016a
8.3514a

4.4565
3.7969

7.2396a

7.8860

1.1588a

3.2518

0.6745a

15.2517

Truman

17.1279a

5.4842

Eisenhower

17.4953a

4.9730

Kennedy

19.2252a

4.6425

Johnson
Nixon

10.8107a
13.2144a

3.4685
3.6237

Ford

19.7155a

4.8105

Carter

20.7155a

4.7321

Reagan

20.7134a

4.9327

Bush_Senior

18.4011a

4.4830

Clinton

11.6547a

3.3528

8.5876b

2.3996

Approval_Lag

Bush_Junior
Adj. R-squared
F-statistic

0.1364
37.32

0.8083
2484.04

Prob(F-statistic)

0.0000

0.0000

Variance Equation
Intercept

5.6542b

2.4841

ARCH(1)

0.4675a

3.0010

GARCH(1)

0.3837a

2.7975

This table presents regressions linking the Gallup presidential approval rating to a number of explanatory
variables described in detail in the data section. The sample spans from Q1 1950 to Q3 2007. Equation 1 is
estimated via the Ordinary Least Squares method, whereas Eq. 2 uses the Maximum Likelihood method
and assumes that the residuals follow a GARCH(1,1) process
a

Denote statistical significance at 1%

Denote statistical significance at 5%

the regression. In so doing we attend to the concern of Gronke and Brehm (2002:
425), who note that Volatility is an important but mostly neglected aspect of
presidential approval. This gives us, then, the following specification of Eq. 2,
which is subdivided into the mean and variance equations, as delineated below:
Approvalt b1 PE Ratiot b2 Scandalst b3 Militaryt b4 Inaugurationt
b5 Discomfort Indext b6 Approvalt1
X11

b Presidential Binary Variablei;t "t ;

i1 6i
where "t  N 0;ht and ht g 0 g 1 ht1 g 2 "2t1 :

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In the Eq. 5 above, t stands for the regression residuals and ht denotes their
conditional variance.
Equation 2 is a very satisfactory regression. All variables are statistically
significant at the 5% level or better, including the ARCH and GARCH effects,
and all of the coefficients have the signs we would expect. Moreover, the adjusted Rsquared indicates that the model fits the data well, with over 80% of variation in
presidential approval being explained. The coefficient on the lagged value of
approval is significantly below unity, which indicates that the time series is
stationary.9 And it is perhaps also worthy of note that the z-statistic for our central
variable of interest, the P/E ratio, has an impressive value of almost 8.4. Indeed, the
lagged term aside, this ratio is the most significant predictor of presidential approval
of all the constituent variables in our new equation. We can also see that the impact
of a one point increase in PriceEarnings is associated with a contemporaneous
increase in presidential approval of approximately 0.61 percentage points. However,
given the dynamic nature of our model, we can also compute the long-term impact
of a change in the P/E; we find that for each increase of one point in the latter, we
would expect a consequent long-term change in presidential approval ratings of
0.6064/(1-0.6745) 1.9 percentage points.
Put in a more recent context, George W. Bush achieved his record approval
ratings in late 2001, following the events of September 11th. Since then, the
aggregate PriceEarnings ratio declined from approximately 46.4 in the fourth
quarter of 2001 to a value of 19.0 in the third quarter of 2007. This decline of 27.4
points, multiplied by the estimated factor of 1.9, translates into a long-term slide in
approval of approximately 52.1 points. Over the same period, the actual observed
drop in overall support for the president was 54.6 points.
As to our other variables, those that can be considered as part of a Bread and
Peace combination (Military, Discomfort_Index) are both important determinants
and suggest that the general public enjoys times of prosperity and domestic security.
The honeymoon effect (Inauguration) registers solidly, as does the negative impact
of Scandals. The coefficients on the variables for presidents draw out the influence
of specific incumbents that are not related to the effects of the other control variables
already covered. They show, unsurprisingly, that ceteris paribus, the individual
impact of Jimmy Carter was most positive and that of George W. Bush the least.
4.2 Specification in first differences
As Harvey (1980: 707) notes, regressions in levels can occasionally be vulnerable to
problems of spurious correlations. It is possible to alleviate this problem by
concentrating on first differences alone although, as Harvey correctly argues, it is
more important to assess the regression on statistical grounds. To demonstrate
robustness, Table 2 shows the relationship between first differences in presidential
approval and changes in the P/E ratio. The explanatory variable in Eq. 1 is highly
9

We have also conducted Augmented Dickey-Fuller tests on the residuals from our regressions specified
in levels. The tests included a constant and a time trend, and lag length was selected using Akaike
Information Criterion with the maximum lag length set at L=4. The tests strongly rejected the null
hypotheses of the existence of unit root in the residual series.

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Table 2 Modeling the changes in presidential approval

Variable

Equation 1

Equation 2

Coefficient

t-Statistic

Coefficient

z-Statistic

0.0620

0.1483

4.6118b

3.1614

2.0873

0.6628b

4.8151

Approval_Lag

0.0922b

3.5542

Inauguration

7.5724b

Intercept
PE_Ratio

0.4916

Discomfort_Index
Military

0.5494

16.1468b

10.3292

2.7004

1.7249

Scandal_Outbreak
Adj. R-squared

0.0144

F-statistic

4.36

Prob(F-statistic)

0.0380

8.6174

0.2350

0.3105
48.35
0.0000

Variance Equation
Intercept

4.8530

1.3698

ARCH(1)

0.1945a

2.4870

GARCH(1)

0.6353b

3.7963

Equation 1 represents an OLS regression of the first differences in the Gallup presidential approval rating
on the first differences in the aggregate PE ratio. Equation 2 uses the Maximum Likelihood estimation
method and assumes a GARCH(1,1) process for the residuals
b

Denote statistical significance at 1%

Denote statistical significance at 5%

Denote statistical significance at 10%

statistically significant, which attests to the strength of the underlying relationship.

The second specification reported follows Erikson et al. (2000) in that it includes a
lagged Approval as a regressor. The coefficient of the Approval_Lag variable is
negative and statistically significant, which implies both that it is relatively easy to
lose support from an initial high and to regain it from desperate lows.
As well as the regressor suggested by Erikson et al. (2000), we include a number
of other variables to mirror the first table. These are Inauguration, here registering in
a single quarter for each presidency, Scandal_Outbreak, again scoring in only one
period (this time when an unsavory episode first comes to public attention). Both
take values of one in any period in which they occur and zero otherwise. There are
also two continuous variables which represent the first differences in the previously
defined Discomfort_Index and Military. For this group, all the coefficient signs are
as expected with only Discomfort_Index proving insignificant. While Scandal_
Outbreak is only significant at the 10% level, it nevertheless illustrates that scandals,
almost by definition, damage the standing of incumbents. The significance of the
coefficient for acceleration in the rate of increase of military spending relative to
GDP, captured by Military, may reflect greater reticence towards military
adventures on the part of the American population than that displayed by their
political leaders. Inauguration, in this iteration, again sharply captures the goodwill
towards newly-elected presidents, as previously discussed.

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117

The clustering indicated by the ARCH and GARCH effects in the residuals of
Eq. 2 is of considerable interest. Since these relate to changes in level of approval, as
opposed to the level of approval itself tested in Eq. 2 of Table 2, they suggest that
rapid shifts in approval coalesce over time. This finding could be consistent with
voters initially having less complete information about the new presidential
administration and its impact upon economic performance, which becomes more
complete with increasing experience. One could postulate that these informational
asymmetries are reduced as voters learn in a Bayesian fashion, with the consequence
that subsequent changes are less pronounced. Similar effects might also be expected
as a presidency comes to an end and election-oriented communications abound,
often emphasizing the historic failings of the incumbent.
4.3 Two-stage least squares estimation
A plethora of studies investigating the nexus of stock markets and politics at least
implicitly assumes that the performance of the former is dependent upon the latter.
However Davidson and MacKinnons (1989, 1993) endogeneity test could not reject
the null hypothesis that the PriceEarnings ratio is exogenous in our model. Thus,
although there seems little statistical justification for instrumenting the PE_Ratio, the
prevalence of an assumption that politics drive stock markets in the literature
prompts us to apply Two-Stage Least Squares (2SLS) estimation. This method
initially focuses on the determinants of the PriceEarnings ratio, and then uses its
fitted value as an explanatory variable in the second stage (for a more detailed
description see Johnston and DiNardo (1997: 157 et passim)). The regressions from
both stages of this procedure are presented in Table 3 below.
In our case, 2SLS demands that a minimum of 17 variables are used to model the
behavior of PE_Ratio (Johnston and DiNardo 1997: 157). We use 16 variables taken
from the previous specificationthat is, all of the variables except Approval and
PE_Ratioand these are treated as exogenous within our system. We also include 4
additional instruments; 3 of which (Payout, Risk and GDP_Growth) have been
already described in the data section above. The fourth additional instrument,
PE_Ratio_Lag, is included to model persistence in the dependent variable.
The results in panel A of Table 3 give strong support to the theoretical model
derived in Eq. 2 above. Both the payout policy of US companies and the risk
influencing the discount rate are shown to be robust predictors of the value of the
aggregate PriceEarnings ratio. Our proxy for growth expectations is signed
correctly but the corresponding p-value is only 0.15not entirely unexpected given
the inexactitude of the proxy employed. The series is strongly persistent, but appears
to be stationary. None of the exogenous variables are statistically significant, which
reinforces the result of the Davidson and MacKinnon test. The adjusted R-squared is
almost 94%, implying that this procedure is not subject to the difficulties that can
arise in the presence of weak instruments (Hahn et al. 2004).
The fitted value of the PriceEarnings Ratio (PE_Ratio_Fit) is subsequently used
as an explanatory factor in the model presented in Panel B of Table 3, addressing the
issue of possible endogeneity bias. PE_Ratio_Fit is significant at the 1% level,
demonstrating that the relationship with presidential approval remains strong,
regardless of the estimation method. The reduction in the value of the t-statistic

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J Econ Finan (2012) 36:106122

Table 3 Results of the 2SLS estimation

Variable

PE_Ratio_Lag
Risk

Panel A

Panel B

Dependent Variable: PE_Ratio

Dependent Variable: Approval

Coefficient

Coefficient

t-Statistic

0.8514a

22.1501

0.7617b

2.0648

GDP_Growth

0.1902

1.4328

Payout

7.8878a

3.6672

PE_Ratio_Fit

t-Statistic

0.2817a

2.7784

Scandals

0.6694

1.2164

5.4769a

3.1800

Military

0.4234

0.5507

2.8664

1.2446

Inauguration

0.2447

0.5477

8.5056a

6.0229

Discomfort_Index

0.1744

1.4634

1.2687a

3.5897

0.0076

0.5592

0.7140a

16.7165

Truman

2.2631

1.4880

17.6810a

4.7909

Eisenhower

1.2533

0.9279

21.2738a

6.0603

Kennedy

0.9301

0.6104

21.7397a

5.1817

Johnson

1.0465

0.8397

15.8361a

4.7103

Nixon

1.0244

0.7822

17.7313a

4.8748

Approval_Lag

0.1288

0.0845

23.4192

5.2742

Carter

0.4323

0.2975

20.8015a

4.9167

Reagan

0.3175

0.2159

22.7974a

5.5345

Bush_Senior

0.0506

0.0340

20.0906a

4.8290

Clinton

1.2175

1.0279

16.8046a

4.6293

Bush_Junior

1.5414

1.2804

14.3724a

3.8245

Adj. R-squared

0.9379

Ford

F-statistic
Prob(F-statistic)

182.94
0.0000

0.8269
69.37
0.0000

This table presents the results for the Two-Stage Least Squares estimation. The regression in Panel A
models the aggregate PriceEarnings ratio as a function of several exogenous and instrumental variables.
Panel B, on the other hand, links the presidential approval rating to the exogenous variables, as well as the
fitted value of the PE_Ratio. The sample spans from Q1 1950 to Q3 2007
a

Denote statistical significance at 1%

Denote statistical significance at 5%

relative to that in Eq. 2, Table 1 is noteworthy but easily rationalized. Although the
2SLS method can remedy problems related to bi-directional feedback, it is limited by
an assumption of constant residual variance. In the presence of heteroscedascity,
which has already been demonstrated, parameter estimates are rendered inefficient.
Regardless of the deficiencies of each of our individual models, the relationship
between PriceEarnings ratio and support for the incumbent president remains
robust.

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119

4.4 Vector autoregressive model

Finally, we consider the Generalized Impulse-Response Function from a Vector
Autoregression (VAR) model, a methodology explored in more detail in Hamilton
(1994), to model presidential approval. As pointed out by Halcoussis et al. (2009), in
certain cases it may not be immediately apparent whether it is politics influencing
the stock market or vice versa. The methodological approach used here has the
added advantage of being robust to any possible endogeneity bias. Thus, in this
specification, PE and Approval are treated as endogenous variables, while Scandals,
Military, Inauguration, Discomfort_Index, and presidential binary variables are
considered exogenous. In testing for the optimal lag length, we use Akaike
Information Criterion (AICsee Akaike 1974) and impose a ceiling of 10 lags to
ensure sufficient degrees of freedom for the subsequent estimation. The AIC
procedure for model identification indicated that the inclusion of 9 lags would be
optimal. As the graph in Panel A shows, after PE_Ratio is shocked by one standard
deviation, Approval remains elevated throughout, and statistically significantly so for
roughly 2 years. The graph in Panel B, plotting reaction to perturbation of Approval,
reveals a much less emphatic response in PE_Ratio, further demonstrating the
solidity of our findings (Fig. 1).

5 Conclusions
As demonstrated in this paper, the PriceEarnings ratio can be seen as an expression
of expectations of the future performance of corporations, including perceptions of
attendant risk. It should, therefore, come as no surprise that there is a relationship
between the ratio and presidential approval ratings. Our modeling of this nexus has
identified a relationship that is surprisingly robust across different econometric
specifications, with P/E accounting for a substantial proportion of variation in the

Note: This figure plots a generalized impulse-response function from a Vector Autoregression model with 9 lags, which takes
the Approval and PE_Ratio to be endogenous and treats Scandals, Military, Inauguration, Discomfort Index and presidential
binary variables as exogenous.

Fig. 1 Response to generalized one standard deviation innovation 2 Monte Carlo response standard
errors

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J Econ Finan (2012) 36:106122

level of presidential approval. From the point of view of policy-makers, this model
appears very attractive; providing a simple, readily and freely available gauge of
voters sentiment. Of course, as with any measure predicated on the stock-market,
there are caveats. Bubbles will be reflected in exaggerated valuation ratios and, as
many financial failures have shown, there are always some firms misreporting
earnings (see for example, Smith 1992). Nevertheless, the ratio remains one of the
most important variables in explaining approval levels, sending a resounding
message: Its the P/E ratio, stupid!
The only variable that exceeded the statistical importance of PriceEarnings was
that for the lag of approval. However, our model shows that the other factors that we
included in our model are also pertinent. The pair that can be molded as peace and
prosperity were, unsurprisingly, revealed as of continuing interest to voters, while
scandals and warmongering tarnished presidential images. The time-invariant
component attributable to individual presidents ranged from the low of George W.
Bush to the high of Jimmy Carter and had explanatory power beyond proxies that
captured the business cycle.
Within the vibrant academic discussion of what influences voters preferences,
our model helps clarify some of the issues surrounding the Bankers or Peasants
debate. In particular, as Erikson et al. (2000: 297) suggest, it is abundantly clear that
people amalgamate past experience and future judgments in assessing their leader.
Our analysis builds upon the theoretical outline developed to show that when
searching for expectations about future economic conditions, information gleaned
from financial markets can be a reliable indicatorone that improves upon limited
survey data. Further, the strength of the model implies that voters are able to discern
underlying economic conditions and are not likely to be easily swayed by short-lived
fiscal manipulations.

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