Is global macroeconomic risk off the charts right now, or does it just seem that way?
It’s important for all of us to answer this question, but especially retirees and near-retirees who don’t have as many years to recover from equity losses. If risk really is high, underweighting equities is a good idea. If it only seems high, then overweighting them might make sense.
It’s easy to understand why, from a subjective point of view, risk seems sky high right now. Will the federal government be able to avert a catastrophic default? Will the Federal Reserve persist in raising interest rates even at the risk of causing a recession? Will World War III break out in Europe? Or in Asia? The list goes on and on.
The problem with subjective perceptions, however, is that risk always seems high in the moment. As soon as an event comes to pass, however, our minds rewrite history to make it seem as though it was obvious that things would work out in the way that they did. One consequence is that we always think risk is higher now than it’s ever been in the past.
If you had any doubt about this mind trick we play, think back to the beginning of the COVID-19 pandemic. It was anything but obvious at that time how things would work out. We could have easily slipped into a global economic depression that would have lasted years. With the benefit of hindsight, however, we tell ourselves that it was obvious that monetary and fiscal stimulus would save us from that fate. But the risks we face today? Now they really are off the charts…
Fortunately, a group of researchers have devised a way to objectively measure macroeconomic uncertainty and risk. It turns out that risk today really is higher than normal; it’s higher than 90% of all monthly readings since 1960, in fact.
The researchers who devised this method for measuring economic uncertainty are three economics professors: Sydney Ludvigson of New York University; Kyle Jurado of Duke University, and Serena Ng of Columbia University. They introduced their approach in the American Economic Review several years ago; their Macroeconomic Uncertainty Index (MUI) is updated periodically at Professor Ludvigson’s website.
The professors’ approach to measuring uncertainty focuses on the predictability of 132 separate economic variables. Uncertainty and risk are assumed to be low when these variables’ predictability is high—that is, when forecasters were mostly right, in other words. When forecasts are hugely off the mark, however, risk and uncertainty are assumed to be high. The professors’ MUI is based on an average of the prediction errors across all 132 variables; the accompanying chart plots it back to 1960.
Periods of above-average risk persists
To put the MUI into practice, you would want to underweight equities when it is high and overweight them when the index is low. This strategy works because high-risk periods tend to be clustered together, and equities tend to be below-average performers during such periods.
These tendencies were documented in a recent study by Jordan Brooks, a principal at AQR Capital Management, in a study titled “Certainly Uncertain.” To show that high-risk periods are clustered together, Brooks calculated the MUI’s half-life. It is four years, which means that’s how long it takes for extreme readings to revert to the mean. As Brooks puts it, “macro uncertainty is indeed extremely persistent.”
To show how poorly equities perform when risk is high, Brooks calculated the stock market’s performance during months in which the index is above one—as it is today (its latest reading is 1.025). Relative to the long-term average, the stock market produces an annualized return of minus 16% in these months, versus plus 6% annualized during months in which the index is below 1.
The bottom line: While we’re right to want to underweight equities during periods of high macroeconomic uncertainty, we’ve been wrong to rely on our subjective perceptions to determine when we’re in one of those periods. With the Macroeconomic Uncertainty Index we no longer have to rely on those perceptions.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com.
This story originally appeared on Marketwatch