You’re kidding yourself if you think uncertainty about the economy is unusually high right now. And you’re doubly kidding yourself if you think current uncertainty is a reason not to invest in the stock market.
That’s because economic uncertainty currently is no higher than average. If it is nevertheless so high as to keep you out of equities, then you should seriously reconsider whether you belong in the stock market in the first place.
To be sure, uncertainty is high right now. But it’s always like that. The future is unknowable, after all. And the impressive return that stock market is expected to provide over the long term is compensation for incurring uncertainty and risk. It’s unrealistic and irrational to expect things to be any different.
Acknowledging that risk is high is not saying that uncertainty is higher than usual. It’s not, at least according to the Economic Policy Uncertainty (EPU) index, a comprehensive and objective measure of economic uncertainty. In fact, the chart below shows the EPU within shouting distance of its historical average.
The EPU was created several years ago by three finance professors: Scott Baker of Northwestern University; Nick Bloom of Stanford University, and Steven Davis of the University of Chicago. The EPU reflects “the frequency of news media references to economic policy uncertainty, the number of federal tax code provisions set to expire in future years, and the extent of forecaster disagreement over future inflation and federal government purchases.”
You’ll notice from the chart that the highest sustained levels of the EPU came from late 2008 through 2012. It’s not a coincidence that this period also experienced one of the strongest performances from the stock market in recent decades. The S&P 500 (.SPX), gained a dividend-adjusted 14.5% annualized and the Dow Jones Industrial Average (.DJI), gained 15.2% annualized. Both returns are well above their historical averages..
Clients recently have reacted in disbelief when I present this argument to them, since uncertainty appears to be off the charts. They point out that we face everything from the prospect of a partial government shutdown, an off-again-on-again trade war with China that oscillates with the latest presidential tweet, a European Union that may or may not lose its second-largest economy, and a British government that may or may not survive the next no-confidence vote — to list just a few of the uncertainties du jour.
I have three responses:
- First, there is a difference between political and economic uncertainty. The latter has the most direct impact on corporate earnings, while most of the uncertainty that dominates the headlines is political.
- Second, we play a mind trick on ourselves in trying to compare current uncertainty with how it was in the past. We immediately rewrite history as though it happened in just that way — our narratives remove the uncertainty.
- Third, even if risk were well-above-average now, knowing this wouldn’t help you much. That’s because, other things equal, the stock market declines as risk rises — in order to increase equities’ expected return. To make money from changes in economic uncertainty, you have to know in advance what those changes will be. It’s too late once that knowledge becomes widespread.
The bottom line? While the future is undeniably uncertain, that doesn’t mean risk is higher now than at other times over the last several decades — or that current uncertainty is a reason to avoid equities.
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