In Times of Economic-Policy Uncertainty, It May Be Best to Avoid the Stock Market

WITH THE start of any new presidential administration, there comes uncertainty surrounding economic policy. That is as true as ever, even with Republicans controlling both the White House and Congress.

But how does this uncertainty affect investors portfolios?

We decided to test this question by looking back at 40 years of returns in stock and fixed-income mutual funds and comparing against the Economic Policy Uncertainty Index, a measure used by the Federal Reserve that counts the number of newspaper articles containing the terms "economy," "policy" and "uncertainty."

Broadly, stocks perform better when economic policy uncertainty falls and bonds do better when it rises. But within those tendencies, we find some segments of the market perform worse than others-particularly when uncertainty emerges, as it did around the presidential election.

Our methodology

To conduct our study, my research assistants (Abigia Abebe and Thomas Kang) and I first pulled mutual-fund return data across various asset classes: U.S. large-cap, U.S. growth, U.S. value, U.S. small-cap, international stocks, U.S. fixed income, short-term debt, high-yield debt, international bonds, emerging-market debt and commodities.

We then partitioned returns in these various classes by the level of uncertainty when uncertainty is high (at the 75th percentile or higher), and when uncertainty is low (at the 25th percentile or lower).

Were are we at this moment? Not surprisingly, high economic policy uncertainty.

What we found

Our first finding is that in general when uncertainty is high, it is a bad time to be in stocks. For instance, when uncertainty is at the 75th percentile or higher, the median monthly return for U.S. large-caps is 1.42%. When uncertainty is at the 25th percentile or lower, the median monthly return for U.S. large caps is 1.52%. This difference of 0.10 percentage point a month might seem low, but that is a return difference of 1.2 percentage points a year.

When we look at other riskier stock classes, we see much bigger divergence. For instance, when uncertainty is at the 75th percentile or higher, the median monthly return for U.S. small-caps is 1.52%. When uncertainty is at the 25th percentile or lower, the median monthly return is 1.83%. This yields a difference of 0.31 percentage point a month, or nearly 4 percentage points a year.

Sharp moves

Next and more relevant to our current situation as the White House changes hands, we decided to look at returns in these asset classes when policy uncertainty jumps a considerable amount or when it falls a considerable amount. Here we see even bigger differences in results.

When uncertainty jumps (or rises by one standard deviation in a given month) the median return for U.S. large-caps is negative 2.01%. When uncertainty falls in a given month (a one standard deviation decrease) the median return for U.S. large-caps is 1.85%. This yields a difference of 3.86 percentage points a month.

These results are even more extreme for riskier stocks. When uncertainty jumps, the median return for U.S. small-caps is negative 1.95% a month. When uncertainty falls in a given month, the median return for U.S. small-caps is 3.56%. This yields a difference of 5.51 percentage points a month.

Turning toward fixed-income funds, we see the opposite set of results-indicating that investors are turning to bonds as a haven when uncertainty jumps. For instance, for U.S. fixed-income funds, the median return when uncertainty spikes is 0.63% a month. When uncertainty falls, the median monthly return is 0.18%. This yields a difference of 0.45 percentage point a month.

The key takeaway: If uncertainty stays where it is now, it may be smart to avoid stocks in favor of short-term bonds. But if uncertainty decreases over the next few months, it is best to be in stocks, especially small-caps.