CASTrader Blog

Northern lights and the stock market

This perhaps wins the award for one of the most bizarre yet fascinating academic finance papers (PDF) regarding environmental effects on the stock market I have seen yet (the paper is also at SSRN).  What's more, it provides a direct link between the field of behavioral finance and econophysics, while at the same time potentially providing several stabs in the "death by 1000 cuts" dismantling of the Efficient Market Hypothesis (EMH).  It's an older paper (2003), but searching indicates it hasn't really been reported on in the blogging or mainstream financial world, so I thought I'd give it a shot.

The paper by the husband and wife team of Krivelyova and Robotti proposes that the same Geomagnetic Storms (GMS) from the sun that cause the spectacular northern lights or Aurora Borealis (image courtesy US Air force via Wikipedia  Update: video) also impacts the stockmarket in a negative way.  It turns out that there is a rational explanation here: GMS are well-documented to have all sorts of impacts on human mood and behavior.  For instance, one study found that hospital admissions for depression are 36.2% higher when GMS activity is high.  The authors cite another study that found that the average number of hospital patients with mental and cardiovascular increases two times over quiet periods.  The authors logically make the connection that with all this going on, people would be down on the market during GMS.  So how much of an effect did they find, and is it real or just butter in Bangladesh style datasnooping?  The authors say:

"This effect is statistically and economically significant, and seems to generate some trading gains. For the US, the GMS effect is similar across indices, ranging from -0.84 to -2.51 percent of average annual returns. We also document a more pronounced GMS effect in the pricing of smaller capitalization stocks. We rationalize this finding by noticing that institutional ownership is higher for large cap stocks, while small cap stocks are being held mostly by individuals."

They say GMS impacted about 10% of the study period.  GMS cycles aren't perfectly correlated with sunspot cycles, but they appear to be related.  The authors go on to say (emphasis mine):

"The initial phase is associated with compression of the magnetosphere, resulting in an increase in local intensity. This lasts for 2-8 hours. The main phase is associated with erratic but general decreases in background field intensities. This phase lasts for 12-24 hours and is followed by a recovery period that may require tens of hours to a week. Geomagnetic storms are predictable and persist for periods of two to four days. On average, we have 35 stormy days a year with a higher concentration of stormy days in March-April and September-October."

Related Reading:

Sun Downer: More about the authors and their findings.

GMS Data, even predictions of GMS.

Winter Blues: A SAD Stock Market Cycle:  "Patterns at different latitudes and in both hemispheres provide compelling evidence of a link between seasonal depression and seasonal variation in stock returns: Higher latitude markets show more pronounced SAD effects and results in the Southern Hemisphere are six months out of phase, as are the seasons. Overall, the economic magnitude of the SAD effect is large."

Stock Market Returns: A note on the temperature anomaly (PDF): "Research in psychology has shown that temperature significantly affects mood, and mood changes in turn cause behavioral changes....We examine many stock markets world-wide and find a statistically significant, negative correlation between temperature and returns across the whole range of temperature."

Would you believe Lunar Cycle effects in stock returns?

Stock returns and the weather: "Sunshine is strongly positively correlated with daily stock returns. After controlling for sunshine, other weather conditions such as rain and snow are unrelated to returns. If transactions costs are assumed to be minor, it is possible to trade profitably on the weather. These results are difficult to reconcile with fully rational price-setting."

Spaceweather.com

NASA's Solor and Heliospheric Observatory with this movie of the sun (MPEG)

Suicide and GMS

Cardiac Arrhythmia and Geomagnetic Activity

Sunspots and clouds

Geomagnetic Storms and El Nino (PDF)?  "The 3 to 6 year SML cycles also show a surprising agreement with the naturally occurring climate cycles known as El Nino/Southern Oscillations (ENSO). On the basis of SSC and El Ni˜no records from 1968 to 2003, it is found that a warm ENSO phase (El Ni˜no) takes place at about the middle of each of seven identified SML cycles."

Sunspots and global warming

Behavioral Finance Linkfest

Micromotives looks at new research indicating it can be rational to buy something that is overpriced.

The Big Picture examines James Montier's fear and greed index, which seemed to predict troble ahead prior to the recent meltdown.

A video of Daniel Kahneman's lecture on prospect theory is available. (via PowerSwings)

CXO Advisory summarizes research that examines the investor irrationality factor on stock prices.

TradeFeed looks inside the trader brain.

Psychologists show that money changes everything.

Update: The neuroeconomics of spending - whether you are a tightwad or spendthrift depends on the pain involved.

Behavioral Finance Linkfest

Proof that losing money really is scary:

The fear of losing money can be similar to the fear of physical pain, according to a study of brain scan images.

The finding could potentially shed light on why people who make high risk financial decisions, such as stock market players, sometimes develop anxiety disorders, says Mauricio Delgado at Rutgers University in Newark, New Jersey, US.

More on his study here.

The cost of anchoring:

During the 2004 Berkshire Hathaway annual meeting, Warren Buffett said the following about anchoring:"When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored.

Randomness and the 'Ludic' fallacy:

One of the fallacies that the Prof. Epps character committed was what Nassim Nicholas Taleb has called the "Ludic Fallacy" (to my knowledge, he first coined and defined this term in his forward to Aaron Brown's The Poker Face of Wall Street). As I understand it, the Ludic Fallacy refers to the unfortunate habit of many quantitative professionals (statistics and economics professors, Wall Street traders, management consultants, government technocrats, etc.) to over-simplify the nature of randomness and chance by making mistaken analogies to games ('ludic' -- of or relating to games or play -- comes from the Latin ludus -- game or play) of chance.

The market's patterns are not our own:

The results also suggest that market returns are patterned in a manner that is precisely the opposite from the pattern of human expectations. If we see something rise during the past day and also during the past five days, it is human nature to look for the trend to be our friend and continue into the next several days. Conversely, if the market is down today and has been down over the past week, we naturally consider the market weak and expect further price softness.

But what happens is precisely the opposite.

DKR to launch behavioral finance fund

Behavioral Finance Linkfest

Richard Peterson discusses a new study that examines which parts of the brain are involved in irrational investment choices, which Peterson attributes to greed and fear, based on the areas of the brain active when the decisions were made.  It's hard to agree that the students were experiencing actual fear, given the small stakes (an apparent $25 max payoff/loss) presented to the guinea pigs of the study, until you realize they were (probably starving) grad students locked in an MRI machine knowing their professors are watching their trading ability.

Perhaps this is the reason for the poor timing ability of mutual fund investors, and the apparent lack of alpha, at least in mutual funds:

Poor timing correlates positively with fund alpha (excess risk-adjusted return), to such an extent that the poor timing cancels the alpha even among the best-performing funds.

Peterson also discusses sunshine and the stock market:

The magnitude of the sunshine effect is substantial. For example, in New York City, the annualized nominal market return on perfectly sunny days is approximately 24.8% per year versus 8.7% per year on perfectly cloudy days.

Can brain damage make a better trader?  Or is it simply emotions?

Researchers in a new paper reject investor herding, but find evidence of contrarian behavior.

Quant Investor discusses the strangely consistent price trend of MNCS.OB, which he attributes in part to "group mania."  Update: The stock blows up a few days later.

Do mutual funds that practice behavioral finance outperform?  Short answer: yes based on raw returns; no, based on risk adjusted returns, but interestingly they attract capital at a greater rate and act like value funds.

From James Montier, The Seven Sins of Fund Management:

How can behavioural finance inform the investment process? We have taken a hypothetical 'typical' large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.

Among the sins: they overtrade, they try to absorb too much information, they rely on forecasts, and they have a short term focus.

Update:

This paper discusses "Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows"

In "Disposition Matters: Volume, Volatility and Price Impact of a Behavioral Bias:"

To do this, we use a large sample of individual accounts over a six-year period in the 1990's in order to identify investors who are subject to the disposition effect. We then use their trading behavior to construct behavioral factors. We show that when the fraction of "irrational" investor purchases in a stock increases, the unexplained portion of the market price of the stock decreases.