Monday, December 7, 2009

Consensus shifts ahead of Copenhagen

There are many crowded trades in life and in finance. One crowded trade that I am comfortable with is “the earth is spherical” trade. If the consensus was to shift off that paradigm, analysts would, after the fact, label that view a “bubble” and the market fallout from such a change would be extremely ugly.

After the hacker break-in at CRU, I speculated on what the possibilities might be should the consensus change. Today, as the world looks forward to the Copenhagen summit, the market consensus seems to be starting to shift as a result of the CRU incident. Avner Mandelman recently voiced his skepticism about climate change thesis and the issue of researchers either fudging data or denying others access to data:
Say that a pharmaceutical company's researchers were caught fudging their tests to make their drug look effective; then, when found out, conveniently lost the non-fudged data. If a doctor prescribed for your child the fraudsters' drug, would you let her take it? If you said yes, would we not be justified in saying you are acting irrationally?
If you missed the controvery, the issue isn't about just how a researcher might have used some "trick" to fudge data so that it would agree his model, but the distressing lack of discipline in the scientific method. Judith Curry, an American climate scientist and no skeptic of the climate change thesis, was appalled [emphasis mine]:

What has been noticeably absent so far in the ClimateGate discussion is a public reaffirmation by climate researchers of our basic research values: the rigors of the scientific method (including reproducibility), research integrity and ethics, open minds, and critical thinking. Under no circumstances should we sacrifice any of these values; the CRU emails, however, appear to violate them...

If climate science is to uphold core research values and be credible to public, we need to respond to any critique of data or methodology that emerges from analysis by other scientists. Ignoring skeptics coming from outside the field is inappropriate; Einstein did not start his research career at Princeton, but rather at a post office. I’m not implying that climate researchers need to keep defending against the same arguments over and over again. Scientists claim that they would never get any research done if they had to continuously respond to skeptics. The counter to that argument is to make all of your data, metadata, and code openly available. Doing this will minimize the time spent responding to skeptics; try it! If anyone identifies an actual error in your data or methodology, acknowledge it and fix the problem.
Meanwhile, the financial market consensus appears to be starting to shift. Donald Coxe, former Global Portfolio Strategist at BMO Capital Markets, also indicated his doubts about the global warming thesis. In reporting on Coxe, a reporter commented:
My purpose here is not to weigh in on Mr. Coxe's theory of climate change (which mostly has to do with sunspots) or those of the scientists who disagree with him. But he is worth listening to in this respect: The big money is always, always made by those willing to bet against a deeply held consensus. So if, five or 10 years from now, new evidence has thrown theories of global warming into doubt, enormous profits will be made by those putting their cash on that outcome now.

Quantitative finance = science
While I have my own personal opinions about climate change, I have learned to be flexible and open-minded about my beliefs as an investment and quantitative analyst.

Quantitative finance is much like science. We observe, we form our hypothesis, we test our hypothesis and we try to apply them. If the evidence changes, our models have to change too.

I have observed situations in the past where people have been dogmatic about models and investment processes despite evidence to the contrary. In the short term, these people may be successful in the short term. In the long term, the market will punish them for their views if they are wrong. Some of these models were built by analysts with incredible stature. Not only do some of these people have Ph.D.s from top universities, published in leading peer-reviewed journals, a few are even Nobel laureates.

In fact, why don’t we start a hedge fund with some Nobel laureates, we’ll call it Long Term Capital Management….

Here’s another idea. Let’s take some of these models of mortgages and apply them to how we package mortgage backed securities. We’ll slice up the mortgages into different tranches, from senior to junior and…

Oh, I remember how that turned out.

Good quantitative modelers observe, form hypotheses, test and apply them. So do good scientists.

We all need to thimk and watch out for errors in our data set and assumptions.

5 comments:

Patrick said...

You've got price risk, basis risk, liquidity risk and operational risk, but then there's model risk which is a sort of meta-risk. I think the big opportunities are in exploiting the crass under-hedging of model risk that goes on in large financial institutions, and carbon trading may indeed become one of them.

Kieran said...

I frequent the finance blogosphere, but I come from a family of science folk, including environmental scientists. For some reason, this appears to be a bigger issue in the finance community than anywhere else. This site, Freakonomics, Zero Hedge, Mish, Minyanville, and Finem Respice have all commented, and all seem predisposed to think that climate change is no longer an issue, or that it was always a false issue created by international governments.

Research fraud happens. I could give countless examples in the medical field. The scientists who manipulate data lose credibility. But the underlying issues remain unchanged. We know the way various carbons, methane, and other pollutants interact with atmospheric gases, and we know that they change the atmosphere. That is beyond debate. The precise effect on temperatures today is largely unknowable.

CRU fraud notwithstanding, quoting a money manager on atmospheric science is akin quoting a sports journalist on quantum mechanics. It's simply beyond their purview, and far more likely than not that their opinion will be of no value.

Whatever consensus the money management community comes to regarding climate science, please do let me know, and also, if possible, please let me know if there is any mechanism from which I can open a short position.

bob said...

If you have any doubts about the problems we have look at these avg CO2 ppm figures from the Mauna Loa observatory: no fudging here:

1990 354.16
1991 355.48
1992 356.27
1993 356.95
1994 358.64
1995 360.62
1996 362.36
1997 363.47
1998 366.50
1999 368.14
2000 369.40
2001 371.07
2002 373.17
2003 375.78
2004 377.52
2005 379.76
2006 381.85
2007 383.71
2008 385.57

Its my firm view that many people over 50 simply refuse to do anything to change and refuse to believe the data presented to them.

frithiof.jensen said...

many people over 50 simply refuse to do anything to change


People over 50 has seen the same game in several different incarnation!

If one believes the Assumption(s) that:

1) CO2 is the only cause of climate change.
2) Climate change is always Bad Everywhere, never Good or Indifferent
3) If 1 & 2 holds, the climate must be regulated and we can use CO2 emissions to do it.
4) The Best Way to handle this Obviously Very Important Job is to let "Markets" do it ...

The whole thing unwinds already at '3' and is becomes ridiculous at '4' because we are still seeing the effects of what happened last time "The Market" regulated anything!

'3' falls when one factors in exponential growth because if growth is never checked the gain will be infinite - like it is now when the USD changes full percentages just because of some rumour of what Bernanke may say next Tuesday.

If people are really certain that emissions are important, then they should argue that we reduce "growth", reduce "consumption" and limit fossil consumption at source.

Yet, they are all out peddling the last century "create an infinite amount of derivatives and sell them to suckers-scam" as The Solution and Goldman Sachs (Now With Al Gore) as a force of Good.

It just sucks all way.

CynicusEconomicus said...

Many thanks for your comment on Cynicus Economicus. I can only agree with your post. It is very sad to see science being laid low in this way. Perhpas moving out of alternative/green energy companies might be a good idea at this stage?