Stock Volatility and the War Puzzle
U.S. stock volatility is 33 percent lower during wartime and periods of conflict. This is true even for World Wars I and II, which would seemingly increase uncertainty. In a seminal paper, Schwert (1989) identified the “war puzzle” as one of the most surprising facts from two centuries of stock volatility data. We propose an explanation for the puzzle: the profits of firms become easier to forecast during wartime due to massive government spending. We test this hypothesis using newly-constructed data on more than 100 years of defense spending. The aggregate analysis finds that defense spending reduces stock volatility. The sector level regressions show that defense spending predicts lower stock volatility for firms that produce military goods. Finally, an event-study demonstrates that earnings forecasts of defense firms by equity analysts become significantly less disperse after 9/11 and the invasions of Afghanistan (2001) and Iraq (2003).
We are grateful to David Brown, Mustafa Caglayan, Mark Flannery, Eric Hughson, Sehoon Kim, Nitish Kumar, Mahendrarajah Nimalendran, Sarah Quincy, Ahmed Rahman, Valerie Ramey, Jay Ritter, Mike Ryngaert, Mike Schwert, Matt Spiegel, Jenny Tucker, Baolian Wang, Nick Ziebarth, and seminar participants at the Catholic University of Brasília, the SEA Annual Meeting, and the University of Florida for helpful suggestions. We thank Someswar Amujala, Umut Arac, Peixin Li, and Suzannah Thomas for excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.