War And Government Policy Fears Drive The Equity Risk Premium
What drives the stock market? It’s a fundamental question that traders and investors have been asking for decades. Asaf Manela of Washington University in St. Louis and Alan Moreira of Yale University decided to analyze this question through the lens of the business press. In a forthcoming paper, News Implied Volatility and Disaster Concerns, they systematically analyze the information published in the press from 1890 to 2009 and find that concerns about war and government policy are important drivers of the time-series variation in the premium investors demand to hold stocks.
Naturally, drivers of the stock market have been studied and researched countless times. But Manela and Moreira took a different approach in their research and used machine learning regression techniques to arrive at their answer. Unlike prior work that relied heavily on researchers’ judgment about which events and words are important, Manela and Moreira imposed very little structure, letting the data speak for itself, thus ensuring their findings does not suffer from human biases that come with, for example, the knowledge that the US happened to win its existential wars over this period.
According to Manela and Moreira, the traditional VIX cannot offer the answer to ‘What drives the stock market?’ alone. Manela and Moreira constructed their own measure of the VIX index using OptionMetrics data and several alternative option-based indices that focused on very large events, such as the Great Depression and both World Wars. “Because OptionMetrics offers a comprehensive data set that includes more nuanced data, like implied volatility slopes, it is the natural place to go,” Manela explained.
The news implied volatility index (NVIX) that the researchers created focuses on the words used to describe the spirit of the times. They found that concerns about war – even during the post-WWII period – accounts for half of the variation in equity risk premium. Even if war is physically distant from investors, they price that risk into their positions. Concerns about government policy, meanwhile, accounted for 25% of the variation.
Furthermore, they found that periods of financial market uncertainty over war or government policy push rates of return higher than average for one to two years. On average, if NVIX is higher by one standard deviation, returns over the coming year will be higher by three percentage points. That is large compared with the average risk premium of about 5 to 8 percent.
Date Source: OptionMetrics
Contrast the above findings of Manela and Moreira with the impact of day-to-day concerns on volatility, and the significance is clear. Daily volatility doesn‘t cause enough concern to impact risk premia, but when concern about war or government policy enter the picture, volatility, risk premia, and rates of return increase substantially.
These findings can improve a portfolio manager’s rate of return depending on his/her tolerance and exposure to war and government policy risks. The research suggests that portfolio managers, traders and others can invest more in the stock market when concerns related to war or government policy are high and expect higher than average returns. However, the concerns are priced into the market by the average investor. Insuring this investor against such risk by taking a contrarian position will leave them very exposed, thus testing the limits of their risk tolerance, if these risks increase or materialize.