This story appears in the June 9, 2013 issue of Forbes. Subscribe
Hoover addresses a large crowd in his 1932 campaign. (Photo credit: Wikipedia)
"The only thing we have to fear is fear itself," Franklin Roosevelt once said, and these days the market experts still seem to be heeding him. Along with such old measures as interest rates and indexes of consumer confidence, investment advisors now press clients with a variety of newer "fear" or "uncertainty" indexes, such as the Chicago Board Options Exchange Volatility Index, or VIX.
Still, there's a limiting circularity inherent in our financial advisors' arguments, just as there was in President Roosevelt's. Typically, these counselors justify the addition of a fear index to the mix by treating investing as if it were a sterile experiment, with investors starring in the role of rodent. Investors panic and leap off cliffs like lemmings. All they have to do is stay cool to make money.
Confining market explanations to markets is an old tradition. When investors have pushed back, advisors since the time of J.P. Morgan have insisted on stubbornly mystifying the process. When asked what stocks were going to do, Morgan famously replied, "The market will fluctuate."
But individual political actions and individual politicians in both parties have always affected individual stocks, those owned by J.P. Morgan included. If President Theodore Roosevelt hadn't been so susceptible to
In short, our financial counselors are cowards. They use "markets only" explanations because they don't want to antagonize clients or governments by seeming political. In the process, however, they reinforce the general denial of political impact.
All the more welcome, then, is a new index that does seek to capture the effect of events and politics. The Economic Policy Uncertainty Index, the creation of Scott R. Baker and Nicholas Bloom of Stanford and Steven J. Davis of the University of Chicago, attempts to assess the possibility that action by politicians may do damage, even when the politicians mean well. The EPU's framers start by quantifying the use of the terms "uncertainty" and "uncertain" in the media, not when those terms appear in isolation but when they appear in relation to real-world terms such as "legislation," "White House" or "Federal Reserve." The EPU also tracks the expiry schedule of tax code measures. Its authors allow that the uncertainty generated by a temporary tax cut (a.k.a. stimulus) may outweigh any benefit to investors, a possibility beyond the comprehension of most lawmakers in either party.
The EPU moves in tandem with the VIX on markets but also moves with elections and wars. Upward movement portends slowdowns in investment and hiring. Increasing changes in tax law are powering uncertainty.
The EPU goes back even to J.P. Morgan's day, showing that a higher score on the news component did indeed correlate with the 1907 Panic. President Herbert Hoover loved action so much his nicknames were the "Great Engineer" and "Superman." The EPU news measure duly spikes in 1932, the last year of Hoover's presidency and a year in which the Dow Jones industrial average plummeted to the not-seen-since low of 41.
Franklin Roosevelt advocated "bold, persistent experimentation," a license to act arbitrarily. The EPU suggests that the unexpected delay of the recovery in the late 1930s correlated with the uncertainty generated by Roosevelt's laws and dominance. In the 1990s, when a more moderate Democrat, Bill Clinton, served as President with a Republican-dominated Congress, the index dropped and the stock market rose. Political moderates and political stalemate may be better for portfolios than rule by more extreme leaders. Investment advisors should bring themselves to tell clients that.
Baker, Bloom and Davis are leading us in a marvelous endeavor. Vanguard has already noticed it, and one hopes other firms will acknowledge the possibility that politicians affect markets. That such an opening will benefit everyday investment advice is entirely certain.
