Policy Uncertainty, VIX, and Equity Valuation

Live those dreams
Scheme those schemes
Got to hit me, hit me
Hit me with those laser beams
--Frankie Goes to Hollywood

These pages have considered Princeton economist Robert Shiller's CAPE (cyclically adjusted price to earnings) ratio as one of the better measures of overall market valuation. This Bloomberg piece includes Shiller's warning that markets according to CAPE are at nosebleed levels.

The piece also notes the divergence between measures of 'economic policy uncertainty' and the VIX--a popular measure of fear in the marketplace (labeled 'equity uncertainty' in the graph below). The VIX can also be viewed as a measure of equity market complacency.

Precisely how 'economic policy uncertainty' is measured is not explained in the piece. One might consider it a dimension of the broader construct of regime uncertainty.

That being said, time series plots show it on the rise over the past few years (not just since Trump's election, btw) while the VIX has been creeping lower. Prior to the past few years, measures of policy uncertainty and the VIX were well correlated.

Currently the divergence between the two series is near record highs. Couple that with record high equity valuations and it is easy to conjure future bearish scenarios.

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