What cliff? The stock market doesn’t see much risk in the next three months despite all the talk of a “fiscal cliff” and other economic tragedies to come.
The real economy is weak — high numbers of unemployed and more families on food stamps — but the financial markets seem to be at ease. Standard measures of risk or uncertainty in the stock market suggest everything is fine for now.
Overall risk or uncertainty in the stock market is measured by what is known as the Fear Index. The CBOE Market Volatility Index (VIX) is a measure of stock-option trading from the Chicago Board Options Exchange. The index is now around 14 percent, two-thirds lower than its level last summer, and well below the long-run average of 20 percent.
The index reflects the cost of hedging risk through the sale or purchase of option contracts on the S&P 500 index of U.S. stocks. This cost rises when prices move dramatically in one direction or another — reflecting greater uncertainty over what their price will be in the future.
At the peak of the financial crisis the VIX was over 70, five times the current level. As the crisis abated, the index fell dramatically, but it spiked again in summer 2011 when there were concerns the federal government may default on its debt.
Even with the uncertainty surrounding the November elections, financial markets are calm today. Does this mean there is little or no economic uncertainty out there? Certainly not.
Researchers at Stanford University have devised new measures of economic uncertainty that show much of the weakness we are experiencing today is due to an uncertain future. Professors Scott Baker, Nicholas Bloom and Steven Davis find that since 2008, uncertainty over government economic policy has been twice the level of the previous two decades.
Other research shows this uncertainty is holding back demand. Sylvain Leduc and Zheng Liu, of the Federal Reserve Bank of San Francisco, say the U.S. unemployment rate, currently at 8.1 percent, is at least 1 percentage point higher than it would be without this uncertainty. That’s more than 1.5 million jobs.
Business owners have long been arguing that uncertainty over government economic policy is holding back their hiring and investment plans. Analysts have replied to this concern by saying that it is a lack of consumer demand, not business spending, that keeps the economy weak.
The above research from the San Francisco Fed suggests the two are related. Their measure of uncertainty comes from the Thomson Reuters/University of Michigan Survey of Consumers, which asks respondents each month about how an “uncertain future” will affect their spending, particularly on big-ticket items like cars and homes.
According to this research, consumers’ perceived uncertainty is three times higher than at the start of 2008. An inability to know what economic conditions will be like in the near futures is holding back consumer demand.
Consumers are concerned and unsure about many types of economic policies at all levels of government. At the federal level, tax policy and the availability of employee health benefits are in limbo. At the state level, education spending is at the forefront.
For example, Idaho voters will decide three propositions regarding teacher pay and performance and the spending on technology for the classroom. The outcome of these votes will have a big impact on the state budget, and potentially on local tax policies.
So what explains a low measure of stock market uncertainty but high consumer uncertainty? The answer can be found at the Fed.
The easy-money policies of the Federal Reserve have done little to help the real economy but much to prop up stock prices. In mid-September the Fed announced more bond purchases, which raise bond prices and lower returns, pushing investors into stocks. Like previous Fed announcements, this program supports stock prices but has little to no effect on economic growth and unemployment.
Economists call this result financial repression. Financial repression is any action by the government to channel funds from one area economy to another, often the government’s own debt. Financial repression has risen dramatically since 2008, suppressing risk measures in the stock market but creating a high level of uncertainty in the overall economy.
The stock market may not see the cliff ahead, but the risk of falling is there nonetheless.
PETER CRABB: Professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org.