Prof. Thorsten Lehnert’s study reveals effect on US stock markets

  • Faculty of Law, Economics and Finance (FDEF)
    15 November 2023

The “cultural war” around environmental policy affects US stock markets

Recently, in his column in The New York Times, Paul Krugman argues that in the US “the gap has widened” and Republicans have become significantly less supportive of environmental action while Democrats have been even more so.

“Environmental policy has been caught up in the cultural war”, pretends the US economist. His statement is supported by a recent survey by the Pew Research Center, a nonpartisan American think tank based in Washington, D.C.

Meanwhile, in a study published in the multidisciplinary open access journal PLoS ONE, Professor Thorsten Lehnert, shows that this controversy around US environmental policy creates uncertainty among investors and, hence, affects stock markets.

Prof. Lehnert makes use of a monthly newspaper-based indicator related to energy and environmental regulation that quantifies uncertainty around environmental policy. He explains: “At the beginning, I found it surprising that this uncertainty indicator is significantly higher when the Democrats have e.g. the majority in senate, but when I looked at the stock market reaction, it started to make sense. My first results suggested that this uncertainty negatively affects aggregate stock prices.”

Inspired by these findings, Prof. Lehnert designed a dynamic trading strategy, where the investor actively manages an equity market portfolio that takes less (more) risk when the past environmental policy-related uncertainty is high (low). Overall, for the last nearly 40 years, the strategy produces significant equity-risk-adjusted annual alphas of 5-6%, and even outperforms the well-known volatility-timing portfolio. This is substantial given the simplicity of the strategy.

According to Prof. Lehnert, this is the first study of that kind, but he encourages researchers to further investigate the financial impact of environmental policies. He adds:” Importantly, my results should not been understood as arguments against climate-friendly policies. But, apparently, in contrast to the good intentions, the environmental policy efforts of the Democrats create uncertainty among financial market participants.”