Economic uncertainty must decrease significantly for the US bull market to continue. It is a big task. Given the uncertainty surrounding the outcome of the November elections (both the President and Congress) and lack of progress in the COVID 19 pandemic, economic uncertainty in the US is likely to remain elevated, at least until the election – if not further increasing day .
Equity investors hate uncertainty. Until recently, this inverse correlation between uncertainty and the stock market made sense in theory, but could not be confirmed empirically. Uncertainty seems to be a subjective matter and is therefore difficult to measure. However, this challenge was successfully met a few years ago when three finance professors – Scott Baker from Northwestern University, Nick Bloom from Stanford University and Steven Davis from the University of Chicago – created an Economic Policy Uncertainty (EPU) index.
The EPU reflects the number of cases where the words "unsafe" or "unsafe" appear in six major newspapers along with the words "economic", "economy", "business", "trade", "industry" or "industry" " occurrence. and one or more of the following terms: Congress, Legislature, White House, Regulation, Federal Reserve, Deficit, Tariff, or War.
As you can see from the following graph, which shows the EPU until the mid-1980s, the stock market usually has problems when the index rises.
According to the statistics package of my PC, there is a statistically significant correlation between the subsequent three-month change rate of the EPU and that of the S & P 500
. The r-square is 22%, which means that changes in the EPU predict 22% of the simultaneous changes in the S&P 500. While this is well below 100%, it is much higher than Wall Street's attention for most other indicators recorded.
The past three months are an important exception to this pattern. The EPU has recently risen to an all-time high, and yet the US stock market has covered one of its strongest three-month stretches in its history.
Does this mean that the correlation between the EPU and the stock market has been permanently broken? That seems doubtful. This would only be the case if investors stopped worrying about uncertainty and actually wanted more of it. That would turn almost any investment theory upside down – whether statistical or behavioral.
The usual decline in equity markets in the face of a rising EPU may only have been postponed.
Baker speculates that the exceptional strength of the stock market in recent times not only suggests that investors are no longer averse to uncertainty, but merely "reflects the immense amounts of fiscal and monetary stimulus that have been distributed by the government."
If so, the usual stock market decline may have been postponed in the face of a rising EPU. This in turn indicates that the stock market may have problems 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 poor fundamental economy, the company's reputation remains intact. "I think the EPU's reputation as a predictor of economic growth will remain strong, while the market as a measure of economic performance will not."
Mark Hulbert regularly writes articles for MarketWatch. His Hulbert Ratings track investment newsletters that pay a flat fee for the exam. He can be reached at email@example.com
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