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Political Elections, Uncertainty and Abnormal Stock Returns.

Inspired by the Presidential Cycle theory we came up with the idea to research if political elections in countries influence stock returns in the weeks surrounding election dates. We found the paper of Pantzalis, Stangeland and Turtle (1999) who were the first to ever to find abnormal returns around election dates from 1974 to 1995 in 33 countries which they explained was due to the uncertainty hypothesis (Brown, Harlow, Tinic 1988). They found high abnormal returns in the 2 weeks preceding elections especially for countries that were Less Free. We will check whether this still hold between 1996 to 2011 and find that the effect has largely disappeared for Free countries while Less Free countries still do show slight significant abnormal returns.

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1. Elections and uncertainty in the past

As mentioned in the introduction, our research is inspired by the United States presidential election cycle theory. This theory was developed by Yale Hirsch and later tested by Herbst and Slinkman (1984) among several other authors. It states that markets do well in a presidential election year and even better in the year leading up to this election year. Markets are performing better in years three and four than in year one and two. According to Herbst and Slinkman (1984) this trend occurs because of politicians incentives to stimulate the economy prior to a United States presidential election and pursue inflationary policies after the election period. Our literature study shows us that political events can have a huge impact on the stock market. Elections eventually lead to new political decisions that often affect the economic policy of a country. Voters and therefore investors get an opportunity to influence the course of these policies. Because of the high media attention the information is available throughout the public and the financial markets and as the election outcome becomes more certain, these markets define the economic effects of the outcome. The Efficient Market Hypothesis (EMH) theory states that an investor cant consistently achieve excess returns because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. This theory emerged in the 1960s as it was proven to be accurate in several studies, but along the way skepticism grew on some of the assumptions of the theory. The most frequently questioned assumption is the investors rationality. Investors and researchers have criticized this assumption and found that there are potential opportunities to beat the market. These opportunities emerged due to behavioral aspects such as cognitive biases and heuristics, which several studies confirmed. One of these counter-studies came up with the Uncertain Information Hypothesis (UIH), proposed by Brown et al. (1988). The UIH states that the volatility of asset returns increases when unexpected information is released, because investors are uncertain on how to react to this information and how to set appropriate security prices. (Bush et al. 2010) In the case of political elections, informational efficiency requires that markets reflect news and political trends into prices in anticipation of election outcomes. According to the EMH these prices will not be influenced by an event such as an election. The UIH states that the return is likely to be higher than average when there is an event like an

election. When the outcome of the election becomes more certain the expected return drops and the stock prices rise. Pantzalis et al. (1999) expect the highest uncertainty two weeks prior to the election date, merely because at that time the media attention will be at their peak. These abnormal returns will be expected to remain positive in the week after the election date according to their research. The UIH states that the reduction of uncertainty is combined with positive returns and that the more certain the outcome, the larger the returns. Pantzalis et al. also discovered that abnormal returns around political elections were higher in countries with less economic, political and press freedom.

2. Empirical Methodology
The aim of this study is to examine if investors behave different during political election periods by measuring the returns during election periods relative to the prior 100 week average returns.

2 Data We obtained national election dates from 33 countries through the website from ElectionGuide which is provided by the International Foundation for Electoral Systems (IFES), an international nonprofit dedicated to strengthening electoral democracy. We assigned a level of freedom to each country based on political, economic and press freedom using the designations Free, Partly Free and Not Free calculated by Freedomhouse. This provider of data is a nonprofit organization which supports democratic change, monitors freedom, and advocates for democracy and human rights around the world. We calculated weekly returns on each countrys major stock index obtained by Thomson Reuters Datastream.

2.2 Methodology The methodology used for this research is in line with the methodology used by Pantzali et al. (1999). This study will cover the period from 1995 until 2011 for 33 countries. We will check whether abnormal returns are present in time window (-4,4) which is the 4 weeks before and after election dates at time t=0. Abnormal Returns (AR) and Cumulative abnormal returns (CARs) are computed using weekly returns from the election period (-4,4) which are subtracted by the average 100 weekly returns in the time window (-105,-5). We will statistically check for

significance of results with the Students T- test. Next we will look whether abnormal returns are different for Free or Less Free countries by level of freedom as stated by Freedom House.

3. Results
3.1 Results of Pantzalis et al. Pantzalis et al. found significant and positive market reaction in the two weeks preceding political elections during their sample period from 1974-1995. The positive election performance is strongest for elections in less-free countries when incumbents lose. They found an average AR for 33 countries in week -1 and -2 of 0.50% and 0.82% respectively and a CAR of 1.12% for period (-2,0) and a CAR of 1.93% for period (-2.4). For Less Free countries the abnormal returns were significantly higher with a CAR of 3.81% for period (-2.0) and a CAR of 5.54% in period (2,4).

3.2 Our results In Table 1. (Appendix) we show the results of the abnormal returns for 140 election dates in 31 different countries. The CAR (-2,4), cumulative average abnormal returns in the 2 weeks before election and 4 weeks after election date are a negative -0.02 % for 1996-2011 in contrast to the positive CAR of 0.02 for the period from 1974-1995. In Panel A. from Table 2 (Appendix). we display weekly ARs and CARs of all countries for the period 1996-2005 for every week surrounding the election date. None of the weeks show positive ARs or CARS in fact the returns are slightly negative and not significantly different from zero, were in the paper by Pantzalis et al. (1999) in 1974-1995 the 2 weeks before the election did show significant ARs and CARs. We also looked at the returns for Less Free countries which did show significant positive abnormal ARs and CARs for (-2.0) and (-2,4) albeit much lower than in the period from 19741995. Only Indonesia went from Less Free to Free compared to the earlier study so the

average AR is not lower because most countries have become Free. The abnormal returns surrounding election dates seem to have been largely disappeared especially for Free countries. This could lead us to conclude that markets have become more efficient. A possible reason could be that due to globalization financial markets are globally more correlated than they were before which would give local election outcomes less importance and less certainty to investors about positive local markets. 4 Conclusion In our quest to see if markets are efficient or are driven by human behavior and imperfections we tested returns around election dates. We extended the work of Pantzalis, Stangeland and Turtle (1999), who found abnormal returns during political elections in the 2 weeks preceding election dates explained by the Uncertain Information Hypothesis (UIH) proposed by Brown et al. (1988). Abnormal returns were higher for Less Free countries. In our sample from 1996-2011 for 31 countries we found no significant difference in abnormal returns between election and non- election periods for Free countries. We did find significant positive abnormal returns for Less Free countries in the two weeks preceding election dates, although being very low making it not an investable strategy. We conclude that markets have become more efficient possibly due to higher correlation in global markets.

5 References
Brown, K.C., Harlow, W.V., Tinic, S.M., 1988. Risk aversion, uncertain information, and market efficiency. Journal of Financial Economics 22, 355385. Harrington, J.E., 1993. Economic policy, economic performance and elections. The American Economic Review 83, 2742. Anthony F. Herbst and Craig Slinkman (1984). Does the evidence support the existence of 'politicaleconomic cycles in the U.S. Stock Market? Financial Analyst Journal, May/June 1984, pp. 38-44. Bush, P.J., Mehdian S.M., Perry M.J., 2010. A Cross-Industry Analysis of Investors Reaction to Information Surprises: Evidence from NASDAQ Sectors. International Review of Accounting, Banking and Finance Vol 2 No. 2, pp. 85-103.

Appendix Table 1 Descriptive Statistics for 149 elections in the sample period from 1995-2011, by country Number of Freedom Rankings Descriptive Statistics for CAR (-2,4) elections Mean Panel A all countries 149 -0,02 -0,02 -0,14 0,10 Median Minimum Maximum

Panel B by country Australia 6 Free 0,01 0,02 -0,05 Austria 5 Free -0,15 0,01 -0,68 Belgium 5 Free 0,02 0,02 -0,03 Canada 6 Free -0,07 -0,04 -0,30 Chili 3 Free 0,09 0,14 -0,03 Denmark 5 Free 0,00 -0,03 -0,08 Finland 5 Free 0,05 0,05 -0,04 France 3 Free -0,10 -0,10 -0,11 Germany 4 Free -0,05 -0,05 -0,08 Greece 5 Free -0,02 0,00 -0,20 Indonesia 4 Free( was not free) 0,09 0,09 -0,07 Ireland 4 Free -0,03 -0,04 -0,07 Japan 5 Free -0,05 -0,08 -0,19 Jordan 4 Not Free 0,03 0,03 -0,02 Korea (south) 3 Free -0,04 -0,16 -0,20 Malaysia 4 Partly Free -0,02 -0,03 -0,15 Mexico 5 Partly Free 0,07 0,06 -0,03 Netherlands 5 Free 0,02 0,05 -0,03 New Zealand 6 Free 0,02 0,01 -0,05 Norway 4 Free -0,05 -0,07 -0,22 Peru 4 Free -0,04 -0,15 -0,25 Philippines 6 Partly Free 0,00 -0,04 -0,28 Singapore 4 Partly Free -0,04 -0,11 -0,14 Spain 5 Free -0,05 0,01 -0,24 Sweden 4 Free -0,01 0,01 -0,15 Switzerland 4 Free -0,06 -0,05 -0,15 Taiwan (rep. of China) 4 Free -0,02 -0,02 -0,10 Thailand 5 Partly Free -0,04 -0,08 -0,26 Turkey 5 Partly Free 0,06 -0,02 -0,09 UK 4 Free -0,07 -0,09 -0,11 US 4 Free -0,05 -0,06 -0,13 Freedom Rankings are based on political, economic and press freedom reported by Freedom House Cumulative Abnormal Returns CAR are computed by taking the return of (-2,4) around election day

0,04 0,06 0,09 0,01 0,16 0,08 0,16 -0,09 0,00 0,14 0,28 0,03 0,09 0,07 0,23 0,11 0,17 0,12 0,10 0,14 0,15 0,10 0,18 0,02 0,08 0,02 0,04 0,25 0,31 0,02 0,05

Table 2 Weekly Abnormal returns for weeks 4 to +4 for country indices around political election dates. Week Comparison period adjusted Free AR (%) P-value t-test Not Free P-value AR (%) t-test 0,000 0,000 0,000 0,000 0,001 0,006 0,000 0,001 0,000

Panel A. Abnormal return (AR) results -4 -0,004 0,06 -0,004 -3 -0,001 0,81 0,002 -2 -0,006 0,02 0,001 -1 0,000 0,82 0,004 0 -0,004 0,33 0,003 1 -0,005 0,16 0,000 2 0,001 0,64 0,007 3 0,001 0,82 -0,007 4 -0,006 0,15 -0,001

Panel B. Cumulative abnormal return (CAR) results Weeks Free P-value Not Free P-value CAR CAR (%) t-test (%) t-test (-4,-3) -0,005 0,064 -0,002 0,001 (-2,0) -0,010 0,150 0,008 0,001 (1,4) -0,008 0,187 -0,001 0,047 (-2,4) -0,016 0,087 0,007 0,012 Comparison period adjusted abnormal returns are computed relative to the average return in the same country over the 100-week period from week -104 to week -5.