Will the Policy Uncertainty Index Doom the Trump Rally?

As the markets continue to rocket upwards, Nobel Prize winning economist Robert J. Shiller of Yale University sees danger signals, according to Bloomberg. Shiller gained fame and credibility for his earlier warnings about the dotcom bubble and the subprime mortgage crisis. Two indicators in particular have Shiller concerned right now, Bloomberg reports on March 14.

Investors seem focused like a laser on the potential upsides of Trump administration policies, while largely ignoring downsides that can be just as big, Shiller told Bloomberg. Normally, he added, one would expect that Trump’s haphazard and unpredictable style would spook the markets, which traditionally crave certainty. Instead, trading volatility, as measured by the CBOE VIX Index, has plunged by over 30% since the election. (For more, see also: Is Volatility Good or Bad for Market Performance?)

Meanwhile, another key indicator that's closely watched by policy makers and market forecasters has surged in recent months, the Global Economic Policy Uncertainty Index. The increase in this index is a trend that typically is consistent with a rising - not falling - VIX. "Policy uncertainty is associated with greater stock price volatility and reduced investment and employment in policy-sensitive sectors like defense, healthcare, finance and infrastructure construction," according to a 2016 academic research paper entitled Measuring Economic Policy Uncertainty.

While the Investopedia Anxiety Index gauges investor sentiment by analyzing the topics that are drawing the most reader interest, the 20-year-old Global Economic Policy Uncertainty Index uses the number of newspaper articles discussing policy uncertainty to assess how high the level of concern is.

 Robert Shiller: Yale University

Shiller has other concerns about the Trump rally. One of Shiller’s most notable research efforts is his development of the cyclically-adjusted P/E ratio, or CAPE, which is based on average inflation-adjusted EPS from the previous ten years. This measure reached a historic peak of 45 during the dotcom bubble. Its second highest peak was 29, right before the Great Crash of 1929. Right now it's also at 29. "The market is way over-priced," he told Bloomberg.

In an interview with Bloomberg TV, Shiller said that, despite all these trouble signs, it's entirely possible that the markets can rise another 4% in the upcoming months. He observes that Trump has been "stimulative in a psychological sense" not just in the U.S., but for markets all over the world. Indeed, he added, looking ten years ahead, the markets can be up by 20% to 30% over today "if Trump does well."

Nonetheless, Shiller emphasized that this is a "really uncertain time" regarding the direction of policy, and there will be disappointment if Trump's plans for fiscal stimulus do not materialize or work as promised. Regarding the CAPE ratio, he noted its current value of 29 reflects high expected returns, producing a situation reminiscent of the late 1990s, the early stages of the formation of the dotcom bubble.

Many on Wall Street discount market skepticism from observers even as heralded as Shiller. The reason: many pessimists have been wrong in recent years. Ethan Harris, the global economist for the Merrill Lynch division of Bank of America Corp. (BAC), told Bloomberg that investors may be tuning out bearish warnings after pessimists overestimated the negative effects of events such as the European sovereign debt crisis, the 2011 U.S. debt ceiling crisis and Brexit​. They also have come to expect that central banks such as the Federal Reserve will intervene to prop up the markets in a real crisis. (For more, see also: Bill Gross: QE Is Financial Methadone.)