Democracy, dictatorship, and economic freedom signals in stock market

The performance of 87 stock markets around the world is examined over the period December 1995 through June 2016. Market responses to democracy or dictatorship and several economic freedom measures are estimated. The democracy/dictatorship measures are based on the Cheibub, Gandhi, and Vreeland data system. Measures of economic freedom, property rights, and corruption are taken from the Heritage Foundation indices since inception. Data are used as first differences to capture any response to new information. Democracy/dictatorship has a significant impact on returns; that is, added risk commands a higher return. The stock markets react positively to the release of economic freedom index data. The adjusted change in economic freedom scoring and corruption has a positive impact on market returns, but no effect was found for property rights. These results are consistent with increases in “perceived risk” impacting returns. Lower corruption (a higher freedom from corruption score) should lead to better returns as cash off flow should diminish and either be paid out to the investor or reinvested in the firm. Key conclusions are as follows: Required investment compensation is lower in a democracy than a dictatorship, a reduction in corruption is associated with improving returns, the region of the world where the stock market index is located matters, and positive changes in economic freedom are associated with a positive market return change.