Weather risk can move markets months in advance—stock traders pay attention to these two long-range climate forecasts

To understand how important weather and climate risks are to the economy, watch investors. New research shows that two long-range seasonal weather forecasts in particular can move the stock market in interesting ways.

We often think about forecasts as telling us what the weather will bring in coming days, but the National Oceanic and Atmospheric Administration also predicts weather conditions several months out. These seasonal climate outlooks tell us whether the hurricane season is likely to be active, whether the winter is likely to be snowy or cold, and whether an El Niño or La Niña climate pattern is likely to emerge with the potential to influence weather across the U.S.

I study the impacts of weather on economic activity as an economist. In a new paper, an atmospheric scientist at NOAA and I analyzed the influence of long-range forecasts by looking at the changing prices of stock options over 10 years and thousands of companies.

We found that investors are paying millions of dollars to hedge the risks of what NOAA’s seasonal outlooks might say. Their bets suggest that seasonal climate matters for the success of companies throughout the economy, even in sectors that might not seem especially exposed to weather.

Betting on seasonal forecasts in options markets

When you buy a stock, you buy a share of ownership in a company. The value of that stock is tied to the company’s expected future profits.

When you buy a stock option, you pay for the right to buy a particular stock at a particular price on some particular future date. Importantly, the option is just that: an option to buy, not a requirement to buy. You’ll pay a premium for this flexibility.

If the stock’s value falls, then you can just let the option expire and all you’ve lost is the premium. But if the stock price rises enough, you can exercise the option and buy the stock at the lower price built into the option. Another type of option, called a “put,” lets you sell stock you already own in a similar way.

The prices of these options tell us how uncertain investors are about the future economy.

Imagine that you know NOAA will be releasing its winter seasonal outlook in 10 days. You are considering whether to invest in a ski resort whose profits are directly tied to having a snowy, skiable winter. You expect the forecast to affect the price of the ski resort’s stock, but you don’t know which way it will go.

The more uncertain investors are about a stock’s future price, the greater their expected gains from holding the option: They get all the potential gain from big increases in the stock’s price and none of the downside risk of falling stock prices. And the greater their expected gains, the more they are willing to pay for the option and the higher the option’s price in the market. So, knowing the winter seasonal outlook is coming can make one willing to pay more for an option on the ski resort’s stock and raise the option’s price in the market.

While there are now many forecasts and available data to provide clues about the coming seasons, two forecasts tend to move the market.

Winter, El Niño outlooks affect many companies

We found that, from 2010 through 2019, the prices of options on companies throughout U.S. markets tended to fall once NOAA released its Winter Outlook, in October, and the most important of its El Niño outlooks, released in June.

In other words, before the reports came out, traders were willing to pay a higher price for options that hedge, or protect against, whatever news was going to be released. So, traders must believe that seasonal climate matters for companies’ profits and that forecasters might say something important about the coming season’s climate.

We did not detect similar effects on option prices when either NOAA or Colorado State University released their Hurricane Outlooks in May and April, or when the Farmers’ Almanac released its Winter Outlook in August. Traders seem to distinguish among outlooks based on their perceived quality and on the importance of what these reports are able to predict, rather than on media attention.

The seasonal climate also matters for more than just outdoor industries. We found the June El Niño Outlook affects options on construction, transportation and utilities—all industries that can be directly affected by weather. It also affects options on other sectors, such as manufacturing and education, possibly reflecting spillovers from elsewhere in the economy. NOAA’s Winter Outlook has similarly broad effects.

The only sector that the June El Niño Outlook does not clearly affect is agriculture, which may just reflect that El Niño’s and La Niña’s strongest effects are on winter weather, when most agriculture is less vulnerable.

Traders pay money to wait for El Niño Outlook

Traders’ interest in the June El Niño Outlook is especially interesting because NOAA releases an El Niño outlook every month. Most months, the outlook changes little from the previous month’s forecast. But in June, once spring is past, the ability to accurately forecast future El Niño events suddenly jumps.

We found that traders value that jump in quality.

The June Outlook corresponds with a US$12 million premium each year on average, showing traders are willing to put real money on the line just to know what NOAA will say in its June forecast before they commit to a stock. That’s about four times higher than we found with the average May outlook.

The traders’ hedging shows that having high-quality seasonal climate forecasts matters to investors, just as it does to communities, companies and emergency responders who rely on these analyses to prepare for severe weather seasons.

It also supports the argument that there is value in investing in the technology to improve these forecasts. And it shows the importance of keeping these outlooks confidential until their official release, similar to how the U.S. government closely guards important economic statistics prior to making them public.

This article is republished from The Conversation under a Creative Commons license. Read the original article.