Markets hate uncertainty. The only thing worse than falling markets, is markets full of question marks.
Of course, the future is – by definition – uncertain. That’s one of the few constants in the universe. Measuring uncertainty is also, well, uncertain. Uncertainty is more subjective than (say) volatility, or stock market valuations, or the price performance of assets. Uncertainty is a feeling, rather than a concrete thing.
Three American economics academics, though, put together an “Economic Policy Uncertainty Index” to try to quantify and measure uncertainty. The index in part gauges the frequency of usage of words such as “uncertainty,” along with “economy” and other keywords relating to government policy. This simple approach is surprisingly useful.
The U.S. Economic Policy Uncertainty Index, shown below, has spiked three times over the past 16 years: At the time of the September 11, 2001 terrorist attacks, during the collapse of Lehman Brothers and the start of the 2008 economic crisis and, most recently, with the United Kingdom’s vote to leave the European Union.
The index has a British version that focuses on the use of the same types of words in major British newspapers. As shown below, Brexit caused a spike in economic uncertainty far above any other time this century.
Valuations and Uncertainty
The creators of the Uncertainty Index found that spikes in the index foreshadow a dip in economic performance, including investment, employment and economic output. It’s also related to stock market valuations, as reflected by the price-to-book (P/B) ratio, which measures a company’s share price compared to the value of all its net assets. If the price of a share (and the overall market value of a company) declines while its book value remains the same, the P/B ratio would fall.
The figure below shows the relationship between the P/B ratio of the S&P 500 and the U.S. Uncertainty Index since 2000. The average P/B ratio tends to dip whenever the Uncertainty Index spikes, meaning that share prices often fall after the Uncertainty Index jumps higher.
Statistically, the U.S. Uncertainty Index is negatively correlated with the S&P 500 (the correlation is negative 0.46). When two assets have a negative correlation, it means they tend to move in opposite directions. So when the Uncertainty Index spikes, share prices tend to go down. (See here for more about correlation and how it’s calculated.)
With Brexit, though, this relationship between the S&P 500 and the Uncertainty Index isn’t working. Shortly after the Brexit referendum, U.S. markets climbed to all-time highs.
One reason for this may be that heightened economic uncertainty in the United Kingdom doesn’t directly affect the U.S. That American newspapers wrote about Brexit – which was very big news – doesn’t mean that the American economy, or markets, are affected. Also, Brexit may actually have benefitted American markets, thanks to a “flight to safety” into U.S. markets.
More uncertainty ahead
The index could spike again in coming months. Perhaps Scotland will become independent, or Great Britain will choose a hard exit over a soft one, or Donald Trump could be elected president or China could collapse. Or the cause of a spike in uncertainty could be something no one sees coming.
Any sharp increase in the Uncertainty Index is likely to foretell a decline in markets.
But these drops – in the context of the strength of global equity markets in recent years – have generally been brief. If history holds, that will be the case next time, too.