CAN ECONOMIC POLICY UNCERTAINTY PREDICT MAJOR US STOCK INDEX RETURNS?

Abstract

Financial markets are uncertain, leading to noteworthy impacts on investor behavior, asset valuations, and overall economic performance. Specifically, economic policy uncertainty (EPU), stemming from fluctuations or unpredictability in governmental regulations, policies, and political environments, has become an increasingly pressing concern for investors and policymakers worldwide. In this study, we thoroughly analyze how EPU and other market and economic risk factors affect returns from major US indexes such as the Dow Jones Industrial Average, Russell 2000, S&P 500, and Nasdaq. We conduct a regression analysis (ordinary least squares) utilizing economic data collected over the past 21 (2002-23) years to uncover novel insights into the intricate interplay between EPU, other non-diversifiable risk factors, and financial markets. Our findings demonstrate that EPU is a good predictor of index returns. However, other market factors, particularly the VIX fear index, provide additional context and information. Finally, this study finds that the US stock market is so efficient that stock movements cause the uncertainty and fear indexes to change, not vice versa. Overall, although there is a significant relationship between the stock market, uncertainty, and fear indexes, investors cannot use such indexes to make any abnormal return.

Keywords: Economic Policy Uncertainty, VIX; Fear Index.