How Do You Solve a Problem Like Uncertainty?

(June 13, 2013) — Uncertainty is the curse of financial markets, and can be a curse of their participants. Handily, the Bank of England has published a report on how to measure-and keep a check on-it.

“Economic uncertainty is difficult to quantify. In contrast to variables such as inflation, uncertainty cannot be directly observed, since it relates to individuals’ subjective beliefs about the economy,” the paper said. “There are different types…and there are different sources of uncertainty, from unexpected changes in economic policies to natural disasters or wars.”

The report outlined indicators, including option-implied volatility, company earnings forecasts, and annual GDP growth forecasts, which can help investors see what their peers and analysts think may happen in the future.

But, the bank said, these cannot be taken by themselves.

“Another, rather different measure of uncertainty is based on the number of citations of ‘economic uncertainty’ in the printed press. To the extent that newspapers reflect (and influence) the public mood, this measure could provide a barometer for uncertainty in the economy.” The report said the very structure of the media can influence sentiment to the negative or positive, but taken with economic indicators, the themes can give a useful steer for investors.

As might be expected, during times of high and unforeseen stress, uncertainty measures peak. “In 1998, uncertainty increased in the wake of the failure of the US hedge fund Long Term Capital Management. There was then a double-peak rise in uncertainty during the early 2000s which coincided with the September 11 attacks and the onset of the Iraq war. Conversely, uncertainty was at an unusually low level for a prolonged period just prior to the recent crisis.”

This was short-lived, however, as the bank’s uncertainty index peaked to over four standard deviations above its mean, although the institution admits this may party have been due to financial market participants reassessing the post-Lehman Brothers world, and realising everything had changed.

Despite uncertainty being an issue with which investors must contend-it affects the general economic sentiment and wider market confidence-its effects are fleeting.

“In the past, uncertainty shocks have tended to unwind fairly quickly, so their effects on real activity have not been very persistent,” the report said, citing a year-long time frame for one standard deviation to unwind.

That said, the past five years have remained in the throes of an uncertain environment, which has impacted investor confidence and economic activity.

It appears, for the time being at least, we can only be certain of uncertainty.

To read the entire report, click here.