Putting a Number to Uncertainty and How Much It Can Hurt Markets
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Version 0 of 1. Markets and uncertainty don't mix, as markets hate unanswered questions. Of course, uncertainty is a universal constant in markets and in every other realm of life. But it isn't a concrete thing that can be measured accurately like like volatility or stock market valuations. Measuring uncertainty would mean being able to measure something subjective or a feeling, which isn't an easy thing to do. But three American economics academics tackled this by coming up with a simple and surprisingly useful approach to quantifying uncertainty,called the Economic Policy Uncertainty Index. This index looks at how often words such as "economy," "uncertainty" and other key words related to government policy are used together in major American newspapers. The Uncertainty Index spiked for the third time in the past 16 years following the U.K.'s vote last month to leave the European Union. The other two times that the index has jumped since 2000 were after the Sept. 11 terrorist attacks, and when Lehman Brothers Holdings collapsed and the world plunged into an economic crisis in 2008. There is a British version of the index, too. It focuses on the same key words and how much they are used in British newspapers. The chart below shows that the Brexit caused more uncertainty in the U.K. than any other event in this century -- by far. The Uncertainty Index's creators also found that index spikes often foreshadow a drop in economic performance, as measured by parameters such as economic output, employment and investment. The Uncertainty Index and stock valuations, as measured using the price-book ratio, are also related. The P/B ratio measures a company's share price compared with its net asset or book value. |