This index keeps up with economic uncertainty – and it’s pretty clear about what’s in store for shares on Election Day
Economic uncertainty must decrease significantly for the US bull market to continue. That is quite a task. With uncertainty about the outcome of the November elections (both presidential and congress) and a lack of progress with the COVID-19 pandemic, US economic uncertainty is likely to remain high – if not higher – at least until election day .
Equity investors hate uncertainty. Until recently, this inverse correlation between uncertainty and the stock market was theoretically logical, but empirically impossible to confirm. Uncertainty seems subjective and therefore difficult to measure. But this challenge was successfully overcome a few years ago when three finance professors – Scott Baker of Northwestern University, Nick Bloom of Stanford University and Steven Davis of the University of Chicago – Economic policy uncertainty (EPU) index.
The EPU reflects the number of occurrences of the words “uncertain” or “uncertainty” in six major newspapers, along with the words “economic”, “economy”, “business”, “trade”, “industry” or “industrial” and any of the following terms: Congress, law, White House, regulation, Federal Reserve, deficit, rate, or war.
As you can see in the chart below, which plots the EPU until the mid-1980s, the stock market tends to struggle when the index goes up.
According to my PC’s statistical package, there is a statistically significant correlation between the lagging three-month rate of change of the EPU and that of the SPX of the S&P 500,
. The r-squared is 22%, which means that changes in the EPU predict 22% of simultaneous changes in the S&P 500. While that is significantly below 100%, it is much higher than the r-squares for most other indicators. capture Wall Street’s attention.
The past three months have been a major exception to this pattern. The EPU recently rose to a record high, yet the US stock market turned into one of the strongest three-month periods in its history.
Does this mean that the correlation between the EPU and the stock market has been permanently broken? That seems questionable. That would only be the case if investors no longer cared about uncertainty and actually wanted more. That would turn almost any investment theory on its head – be it statistical or behavioral.
The usual stock market downturn in light of a rising EPU may have only been delayed.
Baker speculates that, instead of indicating that investors are no longer averse to uncertainty, the exceptional recent strength of the stock market instead reflects nothing but “the immense amounts of government fiscal and monetary stimulus”.
If so, the usual decline in the stock market in the face of a rising EPU may have only been delayed. That, in turn, suggests that the stock market may be struggling between now and Election Day (or longer). As Bloom told me in an email, “My fear is that this will end in tears.”
Baker added, “It’s like Warren Buffett’s quote about ‘When a management with a reputation for brilliance tackles a company with a reputation for bad fundamental economy, the company’s reputation remains intact.’ I think EPU’s reputation as a predictor of economic growth will remain strong, while the market as a measure of economic performance will not be. ”
Mark Hulbert regularly contributes to MarketWatch. His Hulbert Ratings keep investment newsletters that pay a fixed amount to be audited. He can be reached at firstname.lastname@example.org
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