A new Level of Human Error in Financial Markets

Here is the gist of the story: you may want to re-calibrate your personal & corporate financial forecasting and risk management models.

Why? Let’s back up a little.

We all experienced mood swings depending on the weather. Bare with me. We know that your body generates Vitamin D from sunlight, which has a mood enhancing effect on the mind. There are plenty of studies linking depression and Vitamin D deficiencies. Additionally, during sunny days, we tend to be more active (releasing serotonin), spend more time in nature (an article on that coming soon), leave the house & socialize, etc. So, no surprise that during grey, rainy days people tend to be a little less happy, productive and engaging.

Why is this relevant? There is well documented amount of research that causally links stock market performance to seasonal affective disorder (or in plain English: seasonal mood swings). And further, mood changes influence risk taking behavior: i.e. happier people tend to make riskier bets.

Even though algorithms took over most decisions made in the financial markets, the remaining analysts still have a big say in many important decisions.

9–18% fewer financial recommendations by analysts affected by bad weather

And these analysts are affected by external stimuli, like, believe it not, a ‘bad weather effect’. For instance, the ones experiencing clouds, wind & rain are 9 to 18% less likely to author recommendations to buy, hold, sell or forecasts during earning announcements. Bad weather seems to create some kind of decision making inertia. On the other hand, photochemical reactions, like the formation of ozone, are more active on sunny, warm days, which is proven to have its own set of negative influences on human health, and thus performance.

So, we conclude (and you probably guessed it): environmental factors can influence stock market performance by affecting the mood of the financial market actors. Let’s extend this insight to another externality: like air quality.

Now, whenever we think of air pollution, pictures of smog-soaked cities in Asia come to mind. It’s obvious that the people living there are affected by toxic air. In fact, in China alone, more than 1M deaths are directly attributed to air pollution. The time lapse video below gives you a sense of how bad it is.

In the West, we expect to be exempt from these massive cuts into our health. Nope. Even minor pollutant levels can have drastic long- and short-term negative repercussions on your cognitive abilities (aka brain function), diminish worker productivity, increase stress levels & work related sick-leaves, destroy your heart, etc. etc. The list is long.

So this comes as no surprise: according to research around Anthony Heyes, bad air quality has a significant impact of the efficient performance of the financial markets. The scientists used air quality measurements on Manhattan Island in NYC to analyze the influence of fine particulate matter (= scientific: PM 2.5, plain English: fine particles that kill you) on decision making capabilities of local financial market participants. The subtext: the effect on cognitive ability and mood. Sounds familiar?

The authors argue, that 1 unit increase in PM 2.5 that downtown Manhattan ‘market influencers’ experience decreases intraday S&P 500 performance by 1.7%. (Market influencers = think of investment banks, rating agencies, traders, …)

1 µg/m3 increase in PM 2.5 = 1.7% lower S& 500 performance

Now get the smog-soaked image of Asian cities back in front of your mind’s eye. How much growth is China missing out because of air pollution? Well, let’s just look at the numbers in NYC as a reference.

Normal, here: the mean daily, pollution levels in NYC, are around 11.5 micro grams of PM 2.5 per cubic meter. During 66 days in 2015, the EPA recommended 24 hr threshold of 35 µg/m3 was breached, where pollutant levels can reach up to 75 µg/m3. As a reference, a 10 µg/m3 increase of PM 2.5 is equal to 0.35 years lower average life expectancy.

If we apply the higher PM 2.5 values to the empirically proven, linear model of Anthony Heyes, an average ‘bad air day’ in NYC is equal to a 17% drop in intraday performance of the S&P 500. That is $3.4T in absolute dollar terms, for Feb 2017 S&P 500 market cap of $20T. This means for each individual market participant (via my faulty & simplified calculation, but you’ll get the message):

· $6.8B lost for an intraday, average S&P 500 company valuation,

· $3.4B lost revenues for S&P 500 index funds (assuming 0.1% fee on transaction value)

· $1.2B lost in taxes (assuming 35% corporate income tax on index fund revenue)

This is either the largest arbitrage, or one of the most impactful business opportunities in history, where all financial market participants have an aligned incentive to eliminate these Billion Dollar market inefficiencies. Including the workers in Manhattan.

But what can you do about it? Hide inside to take cover from air pollution? Unfortunately, 40–68% of particulate matter can creep through the HVAC system into your office. Further, most of the HEPA filters are clogged anyway, which renders them ineffective.

Credit: http://www.politico.com/agenda/story/2017/05/10/indoor-air-pollutants-buildings-000436

You can also influence city officials to push for electrification of Manhattan? Well, less than 15% of all airborne PM emissions are caused by vehicle exhaust, the rest by tires and brake wear and up to 70% of all air pollution is carried in from outside the city from nearby industry. Surely, the return of the bicycle to NYC, the use of public transportation, or work from home to avoid trips to the office entirely, can all contribute to decrease the aggravation of crappy air. Unfortunately, none of these can get deployed quickly enough in the short-run.

What do you think? How do we get all relevant stakeholders on the table and figure out ways to help our beloved investment bankers, hedge fund managers and Wolfs of Wallstreet to breathe crisp and clean air?

As always, thanks for reading. For suggestions or ideas, you can contact me via m.gimpel-henning@mygcs.de