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Saturday, October 11, 2008

Why You Shouldn't Trust The Experts

Update below.

For your amusement, FRB Atlanta's 2003 working paper, entitled "Playing The Field: Geomagnetic Storms And The Stock Market". The sun, as you may have read in the press, has been exceptionally quiet of recent. The solar scientists are staging performance after performance of "Waiting for Godot". Somehow, Cycle 24 just doesn't seem to want to step on the stage.

The abstract of the article:
Abstract: Explaining movements in daily stock prices is one of the most difficult tasks in modern finance. This paper contributes to the existing literature by documenting the impact of geomagnetic storms on daily stock market returns. A large body of psychological research has shown that geomagnetic storms have a profound effect on people's moods, and, in turn, people's moods have been found to be related to human behavior, judgments and decisions about risk. An important finding of this literature is that people often attribute their feelings and emotions to the wrong source, leading to incorrect judgments. Specifically, people affected by geomagnetic storms may be more inclined to sell stocks on stormy days because they incorrectly attribute their bad mood to negative economic prospects rather than bad environmental conditions. Misattribution of mood and pessimistic choices can translate into a relatively higher demand for riskless assets, causing the price of risky assets to fall or to rise less quickly than otherwise. The authors find strong empirical support in favor of a geomagnetic-storm effect in stock returns after controlling for market seasonals and other environmental and behavioral factors. Unusually high levels of geomagnetic activity have a negative, statistically and economically significant effect on the following week's stock returns for all U.S. stock market indices. Finally, this paper provides evidence of substantially higher returns around the world during periods of quiet geomagnetic activity.
If you find the paper's conclusion credible, you may wonder why we're not all elated and sending the stock markets to the moon, since we are in a period abnormally lacking geomagnetic storms. Alternatively, you could argue that the delay in recognizing the risk and lurking losses was caused by the sun's quiet state and postulate that the crash is the sun's fault, because we were all lulled into ignoring the EPDs.

Personally, I doubt the conclusion, but the paper is only 53 pages. See what you think! To whet your whistle, a brief excerpt:
In this paper, we suggest a plausible and economically reasonable story that relates geomagnetic storms to stock market returns, and provide empirical evidence which is consistent with this story.
Update: You can find a treasure trove of FRB research at this link. Following the finance and economics topic link and going to 2003, I offer another paper which examined the question of whether housing prices were linked to incomes and concluded:
Many housing market observers have become concerned that house prices have grown too quickly of late, and that prices are now too high relative to per capita incomes. Prices will likely stagnate or fall, the argument goes, until they are better aligned with income. This idea is often formalized in the housing literature by asserting a long-run equilibrium relationship between house prices and fundamentals such as income, population, and user cost. The validity of this assumption has important implications for how we model house price dynamics. If the assumption is accurate|so that house prices and fundamentals are cointegrated then the error-correction specifcations of Abraham and Hendershott (1996), Malpezzi (1999), and Capozza et al. (2002) are appropriate.

In this paper I have used standard tests to show that there is little evidence for cointegration of house prices and various fundamentals at the national level. I have also shown that bootstrapped versions of more powerful panel-data tests, applied to a panel of 95 U.S. metropolitan areas over 23 years, also do not find evidence for cointegration. This does not mean that fundamentals do not affect house prices, but it does mean that the level of house prices does not appear to be tied to the level of fundamentals. Thus, the levels regressions found in the literature are likely spurious, and the associated error-correction models may be inappropriate.
You may also find a 2003 paper on conflicts of interest at bond-ratings agencies (the NRSROs I have written about) extremely interesting. The abstract:
This paper presents the first comprehensive test of whether well-known conflicts of interest at bond rating agencies importantly influence their actions. This hypothesis is tested against the alternative that rating agency actions are primarily influenced by a countervailing incentive to protect their reputations as delegated monitors. These two hypotheses generate a number of testable predictions regarding the anticipation of credit-rating downgrades by the bond market, which we investigate using a new data set of about 2,000 credit rating migrations from Moody’s and Standard & Poor’s, and matching issuer-level bond prices. The findings strongly indicate that rating changes do not appear to be importantly influenced by rating agency conflicts of interest but, rather, suggest that rating agencies are motivated primarily by reputation-related incentives.
Note the tone of confidence in the conclusion.

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