Politics are dominating financial markets. Day after day, prices react to news about what governments around the world have done or might do.

The markets were jubilant two weeks ago when European politicians announced a deal cutting Greece’s debt in half. U.S. stocks soared 3.4 percent on Oct. 27, while French and German stocks gained more than 5 percent. Early last week, equities gave back those gains when Greece’s prime minister, George Papandreou, announced his intention to hold a referendum on the bailout. When other Greek politicians voiced their opposition to that initiative, markets rejoiced again.

It is stunning that the pronouncements of politicians from a country whose gross domestic product is smaller than that of Michigan can instantly create or destroy hundreds of billions of dollars of market value around the world.

Yet, despite its obvious importance, political uncertainty is notably absent from mainstream finance theory. Indeed, it would be a waste of time to search financial textbooks for models that take into account uncertainty about future government actions.

In a recent paper, we tried to fill this void by developing a simple model of financial markets in which the government has the option to intervene. Since the officials’ political motives are somewhat unpredictable, investors cannot fully anticipate what a government is likely to do.

How do governments affect stock prices? Our model highlights two opposing effects.

‘Greenspan Put’

On the one hand, by intervening in times of trouble, governments effectively provide put protection to stock investors. A famous example from monetary policy is the “Greenspan put,” denoting aggressive interest-rate cuts in response to adverse economic shocks. This implicit put protection makes stocks more valuable by essentially laying a floor under equity prices.

On the other hand, since government policy decisions affect companies across the board, investors can’t eliminate the risk associated with these decisions by holding a diversified portfolio of stocks. Non-diversifiable political risk makes stocks less valuable by raising discount rates that investors apply to future cash flows of companies.

In short, in times of trouble, we expect governments to step in, but we can’t predict exactly what they will do. Which of the two forces will prevail -- put protection or risk -- is unclear.

Our model makes a number of predictions. We should see more government interventions when the economy is weak. Political uncertainty should lift risk premiums and make stocks more volatile and more highly correlated. Political news -- indications of what governments might do -- should affect stock prices, especially in weak economic conditions. In strong conditions, prices should respond mostly to fundamental economic shocks. These predictions appear consistent with recent events.

One of our central predictions is that political uncertainty should make stocks more correlated, or more likely to move together.

To see how this holds up in the data, we measure political uncertainty using the policy uncertainty index constructed in a recent paper by Scott R. Baker and Nicholas Bloom of Stanford University and our colleague Steven J. Davis of the University of Chicago Booth School. This index combines three types of information: the frequency of media mentions of policy uncertainty; the number of tax provisions expiring soon; and the extent of disagreement among forecasters of inflation and government spending. The authors described their index in this column last month.

Stock Correlation

To measure stock correlation, we compute the market-capitalization-weighted average of the correlations between all pairs of stocks that constitute the Standard & Poor’s 500 Index. We calculate this value monthly from daily returns and smooth it by taking the three-month moving average.

The attached chart shows a strong association between correlation and political uncertainty over the past decade.

Clearly, stocks are more likely to co-move when political uncertainty is high, as the model predicts.

Our chart runs through December 2010, but the positive association between correlation and uncertainty continues in 2011. The policy uncertainty index reached record levels during the debt-ceiling dispute this summer. In early September, JPMorgan Chase & Co. reported that the average correlation between the biggest 250 stocks in the S&P 500 Index reached 81 percent, the highest level since 1987. Last week, the CBOE S&P 500 Implied Correlation Index reached 83 percent, twice the level of four years earlier.

The high stock correlations have made life difficult for fund managers. The ability to pick one stock over another isn’t worth much when all stocks move together.

The high correlations also make it difficult for investors to diversify. The old advice that holding 15 to 20 stocks is enough to achieve diversification is clearly out the window. Even holding many more stocks falls short when stock co-movement is almost perfect.

To make matters worse, stocks tend to be more correlated when markets are more volatile. Diversification fails when you need it most.

Given the limited diversification opportunities in the stock market, many investors have turned to havens such as gold and Treasuries. This strategy has a cost, though: Gold pays no dividends and the 10-year Treasury yield of about 2 percent pales in comparison with the 3.9 percent rate of inflation over the past year. Both gold and Treasuries have appreciated in recent years, but further capital gains are anything but guaranteed.

If we could wave a magic wand and make political uncertainty disappear, risk premiums, volatilities and correlations would all subside. Stock prices would rise. Companies would be more willing to raise capital and expand hiring. People would have more money to spend. The dormant cogs of our economy would begin moving again.

Unfortunately, political headlines are unlikely to go away anytime soon. The European crisis is far from over, and the wrangling over taxes and budget cuts in the U.S. is bound to continue. As long as politicians keep us in suspense, businesses will hold back and investors will keep on struggling to diversify. Gold, anyone?

(Lubos Pastor and Pietro Veronesi are professors of finance at the University of Chicago Booth School of Business, and are contributors to Business Class. The opinions expressed are their own.)

To contact the writers of this column: Lubos Pastor at lubos.pastor@chicagobooth.edu; Pietro Veronesi at pietro.veronesi@chicagobooth.edu

To contact the editor responsible for this column: Max Berley at mberley@bloomberg.net