Climate Change and the Stock Market

By November 25, 2018 Blog

No, I am not going to say how climate change impacts the stock market or even more far out how the stock market may impact climate change.  The point here is that the two phenomena share a statistical property that makes both controversial and difficult to interpret.

To get started, take a look at the chart below.  It plots the return on the market minus the return on 30-day Treasury bills over the 101-year period from 1927 to 2018.  The data are taken from Prof. Ken French’s website.  Basic analysis of risk and return predicts that the average return on the market would be significantly greater than the average return on Treasury bills – and it is.  But try to see that from the chart.  The problem is that the underlying relation, that the average return on the market exceeds that on 30-day Treasury bills by more than 8% per year, is dwarfed by the variability of the market returns.  It takes careful analysis and more than forty years of data to identify a statistically significant difference between the two returns.  Trying to draw conclusions from short-run variation in stock prices is a hopeless endeavor.

The same is true of climate change.  Serious long-run statistical analysis leads to the conclusion that human industrial activity has led to, and continues to lead to, a slow inexorable increase in average global temperatures.  This is analogous to the long-run difference between the return on the market and the return on Treasury bills.  But there is immense short-run and location dependent variation in weather.  The California drought, for example, may be due in some part to climate change, but most of it is probably due to random weather variation.  California had prolonged droughts well before the industrial revolution.  What makes interpreting the market or the climate so difficult and controversial is that we humans have short lives and shorter attention spans.  We want to understand things in terms of what is happening now, or at least in terms of what happened recently.  Unfortunately, in the case of the stock market and climate change that is not possible.  The only way to understand either is careful statistical analysis of long-run data.

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