Financial regulatory policy uncertainty: An informative predictor for financial industry stock returns

• News-based financial regulatory policy uncertainty (FRPU) is a predictor of stock returns . • FRPU can predict financial industry stock returns both statistically and economically. • FRPU outperforms other uncertainty indicators and many other predictors. • The predictive power of FRPU stems from the cash flow channel. We find that financial regulatory policy uncertainty is an informative indicator for predicting returns of financial industry stocks, outperforming popular predictive variables both in-sample and out-of-sample. Mean-variance investors can achieve substantial economic gains by allocating assets based on the information provided by the financial regulatory policy uncertainty index. Placebo tests suggest that other policy uncertainty indices do not provide predictive information for stock returns of the financial industry, and financial regulatory policy uncertainty cannot forecast stock returns of other industries. We demonstrate that the predictive power of financial regulatory policy uncertainty stems from the cash flow channel, potentially due to the inhibitory effect of uncertainty on firms’ economic activities.