Markets hate uncertainty. But lots of uncertainty – as there is now – doesn’t mean that markets won’t go up.
Uncertainty is more subjective than (say) volatility, or stock market valuations, or the price performance of assets. To most people, uncertainty is a feeling, rather than a concrete thing.
But three American academics developed a way to measure uncertainty. And according to their gauge, uncertainty is close to an all-time high. The Economic Policy Uncertainty Index quantifies uncertainty by measuring the frequency that words such as “uncertainty,” along with “economy” and other keywords relating to government policy appear in major newspapers and U.S. government reports. This straightforward approach is surprisingly useful.
The U.S. Economic Policy Uncertainty Index, shown below, has spiked four 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; with the United Kingdom’s vote to leave the European Union in June 2016; and with the U.S. presidential elections in November, when it hit its second-highest ever reading. (The gauge saw abnormally high levels in January 2017.)
Uncertainty, markets, and economies
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 average P/B ratio tends to dip whenever the Uncertainty Index spikes. That’s an indirect way of saying that higher levels of uncertainty are bad for stock markets.
Uncertainty also affects trade, in a very direct way. A recent World Bank analysis pointed to higher levels of economic policy uncertainty as an important factor in the decline in growth in world trade last year. Higher levels of uncertainty in 2016 may have cut trade growth by 0.6 percentage points – which would have accounted for three-quarters of the difference in trade growth in 2015 and 2016.
Low fear, high uncertainty… and strong markets
However, global stock markets don’t seem to have gotten the message. Despite higher levels of uncertainty in recent months, the S&P 500 has appreciated about 5.7 percent year-to-date. Meanwhile, the MSCI Asia ex-Japan index, is up 10.1 percent in 2017 so far. The broader MSCI World index is up 5.1 percent.
You might think that high levels of uncertainty would lead to high levels of fear in markets. But right now, that’s not happening. As we wrote last week, the so-called “fear index” of U.S. stock markets is around its lowest levels since 2007.
The “fear index” is the VIX index, which is a measure of anticipated market volatility. The VIX is based on option prices of individual stocks in the U.S. S&P 500 index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up. And volatility is greatest when markets fall.
Does a low VIX reading point toward an imminent market top? Not necessarily. The current low levels of the VIX only indicate that optimism and complacency are high among the largest investors in the S&P 500 index.
How to prepare for the unknown
In the meantime, it’s smart investing to prepare your portfolio for higher levels of fear – and falling markets. Uncertainty doesn’t dictate fear, but markets can’t whistle through the graveyard forever.
Recently, I wrote about one way to insure your portfolio against this risk. And just last week we released the latest issue of the Asia Alpha Advisory, where I explain in a lot more detail why gold is the best insurance for your wealth… why it’s going to go up… and how to buy it. If you’re not a subscriber…
If you’re not already subscribed to the Asia Alpha Advisory, and you’d like to learn more about how you can benefit from it, simply send an email to [email protected] and I’d have one of my team members revert to you.