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Because of their power and influence in financial markets, large institutional investors are often presumed to be cut from a different cloth than your average retail trader. But Lin Sun, an assistant professor of finance at the George Mason University School of Business, has uncovered that even top investors share a very human weakness– their professional acumen can be thrown off by inclement weather. This weather-sensitivity may have strong implications for pricing.
Her recent paper for Journal of Corporate Finance (co-authored with Danling Jiang of Stony Brook University and Southwest Jiaotong University, China, and Dylan Norris of Troy University) studies institutional investors’ response to earnings announcements over a 26-year period (1990-2016). The data encompassed more than 133,000 firm-announcement observations. For each firm-announcement in the study, the researchers identified the firm’s top ten largest institutional investors, and the prevailing local weather conditions at these investors’ headquarter cities (adjusted by seasonal norms) over the two weeks prior to announcement.
When a firm’s major institutional investors collectively experienced significantly worse weather conditions (wind, rain, snow, etc.) than usual, the stock market was slower to respond to earnings announcements that deviated from analyst forecasts in either direction – positively or negatively. This amounted to an approximate ten percent reduction in the range of immediate response, compared to normal-weather announcements. The delayed immediate reaction was corrected over the following months, producing a higher-than-average post-announcement price drift (otherwise known as the PEAD effect).
For firms as a whole, regardless of whether their actual earnings matched analyst forecasts or not, bad-weather institutional investors gave a higher price discount during the pre-announcement period. Once the earnings were announced, there was a correction, resulting in higher average returns during the announcement period.
Generally, firms earn higher returns during announcement months than non-announcement months – finance scholars call the phenomenon earnings announcement premium. But this effect is magnified when a firm’s top institutional investors experience adverse weather pre-announcement. A one-standard-deviation increase in cloud cover in the weeks prior to announcement was associated with a boost in earnings announcement premium of as much as 90%, according to the researchers’ estimates.
If you keep in mind what bad weather looks and feels like, these results aren’t hard to understand. Conditions such as unseasonable cold snaps, washed-out weekends and sunless skies that last for days on end produce a malaise that weighs on our minds, limiting our attention to work. Practical inconveniences such as longer commutes, residential damage and physical discomfort may worsen the distraction.
For institutional investors, bad weather may dull ordinarily sharp market reflexes. When surprising earnings announcements come through, it takes more time for them to register a proportional response. Hence the muted reaction immediately after the announcement, and the heightened drift later on as the magnitude of the news pierces through their mental fog.
Bad weather is also an insistent reminder of what we cannot control. Portfolio managers may hold significant sway on Wall Street, but have no power over the sun or wind. The sense of being out of control creates a heightened feeling of anxiety and uncertainty aversion. In this nervous state of mind, investors may discount shares of firms in the suspenseful period preceding the earnings announcement, for which they compensate once the uncertainty has been resolved – hence, the higher earnings announcement premium.
Past research in behavioral finance has shown that equity markets as a whole are subject to weather effects. For example, a 1993 paper found that cloudy weather in New York City had a significant depressive effect on daily Dow Jones returns. A subsequent study found the same for 26 global stock exchanges, including Singapore, London, Paris and Rio de Janeiro.
Sun’s paper adds needed clarity and specificity to this growing body of literature. It shows that weather-based biases are not confined to amateur participants such as retail investors – even professionals (such as institutional investors) let the rainy day blues get to them. Similarly, a 2017 paper focused on equity analysts – another highly influential group of participants – also identified delayed reaction to earnings announcements associated with unpleasant weather.
It may be that no amount of education, experience or market savvy will wholly insulate stock pricing from uncontrollable events in the surrounding environment. Other examples of such events may include natural disasters, political crises and, of course, pandemics – to say nothing of the mercurial weather driven by the advancing impact of climate change. Metaphorically speaking, the skies are rarely bright, blue, and untroubled for long in our increasingly unpredictable world.
In this context, there simply may not be as great a difference, in terms of susceptibility to bias, between retail and institutional investors as is commonly thought. But because institutional investors manage much larger assets than typical retail investors, it means much more for the market when their trading behaviors are subject to moods or biases, based on bad weather or other conditions.
Source: Danling Jiang, Dylan Norris and Lin Sun (2021). “Weather, institutional investors and earnings news,” Journal of Corporate Finance