Market forecast: Buy cloudy, sell sunny

Hi all!

After so long not updating this website, Here I am, posting the new thing. I post my recent writing in Jakarta Post. The title is Market Forecast: Buy Cloudy, Sell Sunny. You can read it on http://www.thejakartapost.com/news/2011/08/08/market-forecast-buy-cloudy-sell-sunny.html. This one out of 3 my series. My series? yes, I plan to write 3 popular writings from my thesis and publish it in newspaper. Therefore, my thesis not only produce academical paper but also popular writing. Please enjoy it.

Market forecast: Buy cloudy, sell sunny

Rayenda Brahmana, Jakarta | Mon, 08/08/2011 8:00 AM

The next time you are about to trade securities, you may first want to check if it’s sunny outside.

If you remember a fairytale about a lonely sad toad that asked the rain to accompany him, or a TV program for babies called Teletubbies who wait for sunny days, you, as an investor, may end up as a toad or a Teletubby. It’s true! Believe it or not, whether it’s stormy or sunny outside it will influence your stocks and profits.

That’s the conclusion of several studies that have been circulating for some years, information that is not widely recognized by stock market practitioners.

The first research paper discussing the relationship between the weather and the stock market was written by Edward M. Saunder, a researcher at the University of Massachusetts, in 1993.

He found that the cloud cover in New York had an effect on the US stock market. Recently, my two colleagues (Chee Wooi Hooy and Zamri Ahmad) and I found there was a relationship between temperatures and the Monday effect on the Indonesian stock exchange. Our research conclusion was that abnormal returns on Mondays were a consequence of weather anomalies.

Many other scholars around the world have already examined the role of weather on stock markets. Let me give you few examples: Ekrem Tufan from Anadolu University in Turkey; Angel Pardo and Enric Valor from Universidad de Valencia in Spain; Tsangyao Chang and Tse Yu Yang from Feng Chia University in Taiwan; Michael Dowling and Brian Lucey from Trinity school of Business in Ireland; Mark Kamstra from the Schulich School of Business in Canada; and Maurice Levi from Sauder School of Business in Canada. However, it is rare to find a stock market practitioner report covering the weather. Does this mean there is a gap between the academic world and stock market practitioners?

Whether there is a gap or not, two questions here should be answered. First, what is the justification or rationalization of this relationship? And how far it can be used by stock market practitioners?

Actually, the link between weather and behavior is well explained in psychology.

Alana Hansen and her “compatriots” from the University of Adelaide have conducted research that found there was a relationship between high temperatures and mental and behavioral disorders.

Rupa Basu and Jonathan Samet from John Hopkins University found links between temperatures and mortality rates. Sari Kovats from the London School of Hygiene and Tropical Medicine found there was a relationship between heat and public health.

Much evidence also shows that restaurants provide better service on sunny days, and that suicide rates increase on cloudy days. So, there is indeed a clear relationship between the air temperature and human behavior. This is no goofy shot.

So, what important lesson should investors take from this research? Perhaps the most important thing is that our emotions often trump our objectivity too easily. The weather may push our decision making to become more irrational.

Remember, all equity analysts’ models assume that investors will be rational and follow their model to achieve their objective (optimizing profit). Mood disorders caused by weather will lead investors to stray off course and become frantic, a situation when equity analyst’s forecasts will never work.

Indeed, the easiest way to prevent this random factor is by avoiding stock-picking strategies all together. Investors can pursue more mechanical strategies, for example by buying an index fund and holding it for a longer period.

As mentioned earlier, the weather is the sine qua non of the weekend effect. Using weather forecasts as an analysis tool could also be useful in efforts to beat the market by using the weekend strategy.

Could a trading strategy be devised to exploit the weather trend? Probably. How far can it give good returns and in which conditions? Historically, the performance of sunny day stocks is worthier to try. David Hirsleifer and Tyler Shumway, finance professors from Paul Merage School of Business in the US, showed that the annualized average return on perfectly sunny days was 25 percent, while during overcast days was only 9 percent. In keeping with this finding, my research in the Journal of Bioeconomics finds that the Monday effect in Indonesia can be accompanied by an extra 4 percent of returns if the temperature is hot.

However, David Hirshleifer once stated that it is impractical to use weather variables as a stable investment strategy because of the quasi rationality and transaction costs; factors that investors and future research should consider. The most important lesson from this is whether investors are willing to discount their mood in making investment decisions.

In relation to the current Indonesian stock market situation, this information could bring new hope for investors. A declining market makes investors become more frenzied. A weather-induced mood makes matters worse.

Thereby, in this current market situation, investors should not employ stock-picking strategies and start thinking more about a passive investing strategy.

Remember, a sophisticated investor is an investor who can win the market by using suave information. If the academic world has already found it can work, for example, in making capital asset pricing models for securities valuation, it is the time for practitioners to consider the importance of the weather on the stock markets. It is time to buy cloudy and sell sunny.

So, don’t be surprised if one day soon you find a weather forecast on an equity analyst report. Just ask yourself whether you have the guts to bet your hard-earned money on it.

The writer is an IPS fellowship holder and a researcher in School of Management, Universiti Sains Malaysia.

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