U.S. economic uncertainty remains at near-record levels, and the stock market is at an all-time high. If history is any guide, something’s got to give.
That is the message flashing from an index of economic uncertainty created by three finance professors: Scott Baker of Northwestern University, Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago. Before this year, there was a strong correlation between increases in this index and falling stocks. In fact, based on this historical pattern back to 1900, the S&P 500 appears to be about 20% higher than it should be.
Such a signal might seem surprising in the wake of the close-to-final-resolution of the election and hopeful news on the Covid-19 vaccine front. But here is how the professors’ index works.
The index is based on the frequency of mentions in major newspapers of words and phrases associated with economic uncertainty. In the accompanying chart, this index—known as the Economic Policy Uncertainty, or EPU, index—has retreated somewhat from its spike in April and May, but it remains nearly three times as high as its average over recent decades.
In an interview, Prof. Bloom explains that there are several ways in which heightened economic uncertainty hinders economic growth. It raises the cost of capital, for example, which means that businesses are unable to justify as many new projects as they would have otherwise undertaken. It causes both businesses and consumers to delay expenditures. And it reduces the effectiveness of government stimulus programs.