Financial market response to extreme events indicating climatic change

My article "Financial market response to extreme events indicating climatic change" just came out in the "Health, Energy & Extreme Events in a Changing Climate" issue of the European Physics Journal: Special Topics:

A variety of recent extreme climatic events are considered to be strong evidence that the climate is warming, but these incremental advances in certainty often seem ignored by non-scientists. I identify two unusual types of events that are considered to be evidence of climate change, announcements by NASA that the global annual average temperature has set a new record, and the sudden collapse of major polar ice shelves, and then conduct an event study to test whether news of these events changes investors’ valuation of energy companies, a subset of firms whose future performance is closely tied to climate change. I find evidence that both classes of events have influenced energy stock prices since the 1990s, with record temperature announcements on average associated with negative returns and ice shelf collapses associated with positive returns. I identify a variety of plausible mechanisms that may be driving these differential responses, discuss implications for energy markets’ views on long-term regulatory risk, and conclude that investors not only pay attention to scientifically significant climate events, but discriminate between signals carrying different information about the nature of climatic change.

The paper is here, and note that the rest of the issue includes an overview of the climate and conflict literature by Sol, Marshall Burke, and Tamma Carleton, as well as Gordon McCord's article forecasting climate change's influence on malaria ecology.

Weekend Links

1) Madden Julian Conversation: A blog by a small group of climate scientists about the Madden-Julian Oscillation and the DYNAMO field campaign in the Indian Ocean.

2) trefis.com will do your stock price event studies for you. I wonder if "coups" or "corruption" ever show up as a line item.... (h/t Mina)

3) Earth | Time Lapse View from Space, Fly Over | NASA, ISS from Michael König (h/t Ram)




4) Teaching yourself to be a good seminar participant can have negative externalities.

5) NASA is looking for potential astronauts

Weather, stock market returns, and subtlety in causal inference

While hanging out with a few academic friends on Friday I began discussing a recent research paper with someone I didn't know particularly well. It turned out that this guy was the odd man out of the group and instead of being a professor / post doc / grad student he worked in finance, and was not terribly supportive of a lot of empirical work. Trotting out the classic "correlation doesn't imply causation" critique he then said something along the lines of "you could show that rain makes the stock market go up and down and it wouldn't mean anything." This of course reminded me of one of my favorite counterintuitive-but-compelling research literatures: the effects of weather on stock market returns.

Now, first off, it has to be said that one of the nice things about working with climate data and effects is that causality is, in fact, generally pretty easy to establish. While humans appear to be quite good at affecting climate at decadal time scales, we generally are unable to affect day-to-day or even month-to-month weather patterns, and have great difficulty predicting timing and spatial patterns of highly-relevant weather behavior such as heat waves and storms even over a time span of hours or days. While this is bad from a welfare point of view (e.g., we'd love to be able to predict where a hurricane will make landfall a month ahead of time) it means that statistical analyses of the impact of weather itself on a given phenomenon, provided you're careful about your research design, are generally pretty causally attributable. (see important caveat below)*

Given that, it turns out that there's some pretty strong evidence that weather affects stock market returns. There are multiple papers pointing out that stock market returns are affected by local weather (the latter of those containing this depressing gem of wisdom: "behavioral finance shows that lower temperature can lead to aggression, while higher temperature can lead to both apathy and aggression"). My favorite and, as far as I can tell from this literature, the definitive word on the subject so far, is this paper by Hirschleifer and Shumway showing that: yes, stock market returns are affected by the weather; the effect is driven by sunlight or the lack thereof and not precipitation per se; but the effects are so small that the only way to arbitrage across it is if you have absurdly low transaction costs (echoing one of my favorite applied finance papers of all time, Schleiffer's The Limits of Arbitrage).

If the sunlight result makes you think of SAD, or seasonal affective disorder, you're onto something interesting: Kamstra, Kramer and Levi find strong evidence (getting some nice identification off of solar insolation across hemispheres) that stock markets experience something like it, too. A follow up paper argues that one could capture the same result based just on hemisphere-appropriate seasonality and that an explicitly psychological 'SAD' effect is probably not supportable at present, though that finding was in turn disputed by Kamstra et al. Regardless, I'd argue that (a) seasonality driving markets is a fairly interesting idea, as is any result that links natural processes (which, after all, the seasons fundamentally are) and human behavior and (b) this only further impresses the necessity of the important caveat below.

All of which is to say that sometimes what seems at first glance to be a semi-ludicrous postulate can turn out to be quite true. Evidence has been found that stock markets are affected by everything from sports results to lunar phases, and in many cases these relationships seem both intuitive and robust. The question of what those results mean, however, can sometimes be difficult to tease out (have I mentioned the important caveat*?), so a policy proscription or a deeper insight into human nature might not actually be forthcoming. Put in other words, perhaps my finance friend was right: you can show that stock markets are affected by sunny days, but really, what does that mean?

* Important caveat: The fact that weather is exogenous doesn't mean that saying something about mechanisms / pathways / etc. is easy. Weather affects everything from crop production to labor supply to ecology and phenology to the stock market behaviors seen above, so if you're going to make a claim about weather affecting something *through* some pathway, or even more dangerously plan on using it as an instrument, you should be very, very careful. Economists call your justification for claiming causality in such cases your "exclusion restriction," and if there's one concept I'd like to see enter into the general population memosphere, it's that.

Complexity and rent-seeking in the non-productive industry

The New Yorker has an Annals of Economics article this week on finance's role in the American economy titled "What good is Wall Street?" Lest you have any doubt about the author's answer to that question, the subheading is "Much of what investment bankers do is socially worthless." Some brief thoughts, preceded by what I think is the necessary admission that I was an investment banker (doing albeit nonstandard work) for two years:

1. I'm glad that the concept of financial work as a fundamentally rent-seeking activity is getting more mainstream. I'd be happier if this were running in USA Today instead of The New Yorker, but still.
2. I strongly suspect that most people who haven't explicitly had to think about it (by which I mean: most people) still don't understand what finance as an industry 'does'. I think the simple model of what banks do (deposits in, loans out, earn the spread) is pretty widely understood, but how the rest of finance operates, or even what makes up the rest of the financial services industry, not so much. That is a bad thing for a lot of reasons.
3. LSE has a Centre for the Study of Capital Market Dysfunctionality? Seriously? I know several people who would probably love to post-doc there.
4. Sol and I were recently talking about Russia since the Soviet collapse (we're required by contract to spend most of our time trying to distract each other from actual productive work) and he mentioned that it was the epitome of elite capture. Every time I hear stats on the perpetually (even during the crisis) increasing gap between top 1% earners and the median, I think about that process.
5. From my own experience and those of some friends I'd say fresh college graduates' decisions to work in finance are driven by two things. The first is the low option value of a year or two of your early twenties versus the salary proffered; how many people do I know took the hipster / slacker / failed artist route for those years and have little to show for it aside from going to a few more parties? The second is the relative attractiveness of job choice coming out of finance. A first job in finance doesn't drastically reduce one's set of possible careers the way a lot of other fields do because it signals that you're at least passably smart (though probably not brilliant) and you're willing to work like a dog. If we're worried about our best and brightest going to work in finance, which I honestly think is a distraction from more serious concerns like under-regulation, we need to do something about the attractiveness of those two drivers. Since salaries won't likely change soon, I suspect that ultimately means changes in social norms and the social acceptability of going to work in what has largely become a parasitic industry.
6. The author touches on but doesn't really delve into what I think is the heart of the problem: finance has enormous returns to complexity. Firms don't generate huge returns by focusing on banking; they get it by being early-actors in markets that haven't become efficient yet. If the hot new derivative your firm has developed is either sufficiently new that other firms aren't familiar with it or sufficiently complex that other firms can't muster the expertise to price and trade them, then you can escape the margin-killing slide towards efficiency, at least for a few years, and make bank. That finance's ability to support million-dollar-a-year salaries derives mostly from the exploitation of market inefficiencies is something that I think is lost in most discussions, especially when there's so much rhetoric claiming finance makes markets more efficient.
7. The complexity rents argument alone is, I think, sufficient to strongly argue in favor of much heavier regulation and reinstating the separation of normal and investment banks. If we add in a political economy / returns to political contributions element to the model it becomes even more pressing.