TAILIEUCHUNG - The Clustering of Extreme Movements: Stock Prices and the Weather

Using the panel-data approach of Kónya (2006), which is based on SUR systems and Wald tests with country-specific bootstrap critical values, and two different (weekly and monthly) datasets covering respectively the periods from 7 June 2005 to 21October 2008, and from January 1996 to December 2007, we show strong statistical evidence that the causal relationship is consistently bi-directional for Saudi Arabia. In the other GCC countries, stock market price changes do not Granger cause oil price changes, whereas oil price shocks Granger cause stock price changes. Therefore, investors and policy makers in the GCC stock markets should keep an eye. | The Clustering of Extreme Movements Stock Prices and the Weather by Burton G. Malkiel Princeton University Atanu Saha AlixPartners Alex Grecu Huron Consulting Group CEPS Working Paper No. 186 February 2009 The Clustering of Extreme Movements Stock Prices and the Weather Atanu Saha Corresponding author Managing Director AlỉxPartners 9 West 57h Street Suite 3420 New York NY 10019 asaha@alixpartners. com 212 297 6322 Burton G. Malkiel Professor Princeton University 26 Prospect Avenue Princeton NJ 08544 bmalkiel@ 609 258 6445 Alex Grecu Manager Huron Consulting Group 1120 Avenue of the Americas 8th floor New York NY 10036 agrecu@huronconsultinggroup. com 212 785 1313 Practitioner s Digest A striking feature of the United States stock market is the tendency of days with very large movements of stock prices to be clustered together. We define an extreme movement in stock prices as one that can be characterized as a three sigma event that is a daily movement in the broad stock-market index that is three or more standard deviations away from the average movement. We find that such extreme movements are typically preceded by but not necessarily followed by unusually large stock-price movements. Interestingly a similar clustering of extreme observations of temperature in New York City can be observed. A particularly robust finding in this paper is that extreme movements in stock prices are usually preceded by larger than average daily movements during the preceding three-day period. This suggests that investors might fashion a market timing strategy switching from stocks to cash in advance of predicted extreme negative stock returns. In fact we have been able to simulate market timing strategies that are successful in avoiding nearly eighty percent of the negative extreme move days yielding a significantly lower volatility of returns. We find however that a variety of alternative strategies do not improve an investor s long-run average return over the return .

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