By Mark Hulbert

U.S. economic uncertainty remains at near-record levels, and the stock market is close to an all-time high. If history is any guide, something's got to give.

That is the message flashing from an index of economic uncertainty created by three finance professors: Scott Baker of Northwestern University, Nicholas Bloom of Stanford University and Steven Davis of the University of Chicago. Before this year, there was a strong correlation between increases in this index and falling stocks. In fact, based on this historical pattern back to 1900, the S&P 500 appears to be about 20% higher than it should be.

Such a signal might seem surprising in the wake of the close-to-final-resolution of the election and hopeful news on the Covid-19 vaccine front. But here is how the professors' index works.

The index is based on the frequency of mentions in major newspapers of words and phrases associated with economic uncertainty. In the accompanying chart, this index -- known as the Economic Policy Uncertainty, or EPU, index -- has retreated somewhat from its spike in April and May, but it remains nearly three times as high as its average over recent decades.

In an interview, Prof. Bloom explains that there are several ways in which heightened economic uncertainty hinders economic growth. It raises the cost of capital, for example, which means that businesses are unable to justify as many new projects as they would have otherwise undertaken. It causes both businesses and consumers to delay expenditures. And it reduces the effectiveness of government stimulus programs.

The U.K. experience

To illustrate the negative effects of uncertainty, Prof. Bloom points to what happened to the U.K. economy following the country's Brexit referendum in 2016. The U.K. version of the EPU skyrocketed and British business investment fell 11% over the subsequent three years. Investment fell even further during the Covid-19 pandemic, of course.

Over the same period in which U.K. business investment was falling 11%, business investment in the U.S. rose 20%. This difference was mirrored in the relative returns of the two countries' stock markets: In U.S. dollar terms, the MSCI United Kingdom Index lagged behind the S&P 500 over this three-year period by 29 percentage points (assuming dividends were reinvested).

The U.K.'s experience helps us to appreciate why it is so worrisome that the U.S. stock market is near its all-time high in the wake of heightened economic uncertainty. It means that investors face the not-inconsiderable risk that this Wall Street-Main Street disconnect will be overcome by the stock market falling significantly.

The federal government's extraordinary fiscal and monetary stimulus this year has played a major role in preventing that from happening, at least so far. A significant chunk of that stimulus money undoubtedly found its way into the financial markets, propping up prices.

Notice, however, that this government stimulus doesn't actually resolve the Wall Street-Main Street disconnect. It instead merely postpones the eventual day of reckoning.

'Roaring '20s scenario'

One way the disconnect could end without stocks plunging, of course, is for economic uncertainty to fall significantly. This presumably would happen if and when successful vaccines become widely available, the pandemic comes to an end and the economy quickly recovers. Vincent Deluard, head of global macro strategy at investment firm StoneX, refers to this possibility as a "Roaring '20s scenario," drawing an analogy to the economic boom that emerged out of the destruction of World War I and the Spanish flu pandemic.

Businesses themselves don't appear to be envisioning their futures through these rose-colored glasses, however.

Consider the Survey of Business Uncertainty, another tool devised by Prof. Bloom and others, including the Federal Reserve Bank of Atlanta. This survey focuses on what business leaders anticipate over the subsequent four quarters. The latest reading, for November 2020, which reflects survey responses after the Pfizer/ BioNTech SE and Moderna vaccine results had been announced, indicates that uncertainty about sales over the coming 12 months is 70% higher than the average since data began being collected in 2016.

This illustrates the extent to which the long-term economic consequences of the pandemic are far from clear, according to Prof. Bloom.

Even if the Roaring '20s scenario comes to pass and economic uncertainty falls significantly, it isn't clear that the stock market would perform all that well. Since equities haven't fallen as much as they normally would during this year's heightened uncertainty, they might not gain as much as they otherwise would have as uncertainty declines.

The stock market might even fall in a Roaring '20s scenario, according to Mr. Deluard. He says an economic boom would precipitate a major stock-market rotation away from growth stocks to value stocks. He reminds us that such a rotation happened in the 2000-02 bear market, and though the average value stock actually rose during that time, the overall market averages -- dominated as they are by the large-cap growth stocks -- fell.

Mr. Hulbert is a columnist whose Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

12-06-20 1314ET