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Uncertainty and the Oracle of Market Returns: Evidence from Wavelet

Coherence Analysis

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Chapter

Uncertainty and the Oracle of

Market Returns: Evidence from
Wavelet Coherence Analysis
Joan Nix and Bruce D. McNevin

Abstract

Wavelet methodology is employed to investigate the statistical relationship

between three well-accepted measures of uncertainty and both market and sector
returns. Our primary goal is to determine whether uncertainty is sector specific.
Although there are periods when the market works effectively as an oracle captur-
ing uncertainty, we also find sector specific uncertainty. The wavelet equivalent of
correlation, coherence, is used to determine the presence of sector specific uncer-
tainty. We find that allowing localized information in the time frequency domain is
critical for separating out sector specific uncertainty from market uncertainty.

Keywords: finance, sectors, wavelets, uncertainty, coherence

1. Introduction

Uncertainty shocks call the the market’s knowledge-gathering role into question.
The equity market as an oracle works well when it provides rapid price discovery
that reflects the underlying fundamentals of an economy. But when facing uncer-
tainty shocks the equity market’s function as a consensus mechanism that reveals
economic reality appears at first glance, poorly suited for the environment it faces.
An oracle needs a reliable channel for obtaining information. In the face of uncer-
tainty, the equity market turns into a network of pipes where funds flows in ways
that leave many skilled observers of market moves caught off guard. The shock
filters through to the inter-temporal trade-offs of investors and makes forecasting
more of a bet on imagined scenarios than the result of astute modeling that is
carefully tested with historic data.
The relevance of wavelet methodology for examining whether the uncertainty
measures are correlated at different scales and frequencies with market and sector
returns may be more easily imagined with a metaphor.1 The uncertainty shock
operates as a push from behind that a person strolling down the street experiences.
The push may be hard and throw the person completely off his path. He may end up
face down and in a panic imagining the worse outcome. The push may also be soft
from which the person experiences a quick feeling of panic but quickly recovers and

1
The use of imagery as a guide to economic understanding has a rich history. See for example, the use of
a bicycle imagery by Samuelson to explain how a real economic system is capable of resolving
indeterminacy even when the path between present and future is far from smooth [1].

1
Wavelet Theory

continues his walk. It is not that the person is caught completely off guard. The push
comes after a signal such as the sound of feet running from behind or the quiet
sound of someone walking at a slightly faster rate to catch-up. The relationship
between the signal and push is based on short-lived features of the environment.
However, very different outcomes are possible. Wavelet methodology is particu-
larly well-suited for capturing these different outcomes because it is designed to
capture short-lived features of the environment. Wavelet methodology provides a
snapshot of the outcomes in the form of market and sector returns that result from
various shocks.
A defining feature of wavelet methodology that makes it particularly well-suited
for capturing the economic effects of uncertainty shocks is that at a given point in
time the same signal can be analyzed by different wavelets. Most importantly, it is
capable of capturing an uncertainty signal that only lasts for a finite period of time.
It can also handle non-stationarity which often characterizes uncertainty shocks.
Wavelet coherence plots help us discover whether the measures of the shock
provide new information that is not reflected in market and sector returns at
various scales.
In this chapter, we investigate the statistical relationship between three well-
accepted measures of uncertainty and both market and sector returns. The three
measures are Macroeconomic and Financial Uncertainty of Jurado, Ludvigson, Ng
(JLN) [2] and Economic Policy Uncertainty by Baker, Bloom and Davis (BBD) [3].
We explore the extent to which the impact of uncertainty is sector specific.
Employing the wavelet equivalent of correlation, we observe that in the presence of
significant coherence, market returns are anti-phase with all three measures of
uncertainty. Between market volatility and financial uncertainty, we also observe
very high in-phase coherence at low frequencies for prolonged periods of time.
However, this is not the case when considering the volatilty of Economic Policy
Uncertainty or Macro Uncertainty. For those measures, while there are periods of
high coherence, these periods are not as extensive as found with financial uncer-
tainty. One conclusion is that the prolongness of the coherence differs depending on
the measure of uncertainty.
Looking at the coherence plots with sector returns and the three measures of
uncertainty, we find prolonged high coherence at low frequencies and intermittent
coherence at high frequencies. For each coherence plot, we also consider the condi-
tional coherence, after partialing out the effects of the market. By and large, most of
the coherence disappears pointing to the question of whether there is any sector-
specific uncertainty. Our focus is on six sectors, Telecom, Bus. Equip, Shops.
Manufacturing, Energy and Money where each had at least one period of high
conditional coherence. For each sector, based on our observation of the conditional
coherence plot, we sampled the scales using a Discrete Wavelet Transform (DWT).
A DWT is used to run a regression of sector returns against both an uncertainty
measure and market returns. A rolling regression is used from which we find the
time-pattern of the uncertainty coefficients. It was often the case that the uncer-
tainty had a significant negative impact on sector returns. These snapshots that the
wavelet coefficients provide point to the general result that there are significant
differences in how uncertainty filters through the sectors that are different from
what the market reaction alone tells us.
The remainder of our chapter proceeds as follows: Section 2 highlights research
based on wavelet analysis in applied financial economics of particular relevance for
our analysis. The important concepts used in wavelet analysis that are applied in our
analysis are introduced in Section 3. The data and uncertainty measures are
discussed in Section 4. The analysis and results are presented in Section 5. The
conclusions follow in Section 6.

2
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

2. Literature review

The modern strain of literature relating to uncertainty, and its effects on the
economy, grew out concerns in the post credit crisis era that firms were holding off
on investments due to uncertainty about the future. Bloom [4] shows that a number
of cross-sectional measures of uncertainty are correlated with time series measures
of volatility. The cross-sectional measures of uncertainty he considers are the stan-
dard deviation of pre-tax profit growth, a stock return measure and the standard
deviation of total factor productivity. His time series measure of volatility is stock
market volatility. In addition, he evaluates the impact of uncertainty on the real
economy using a VAR. He finds that a shock to stock market volatility causes a 1
percent drop in industrial production over a 4 month period. He also reports a
similar effect on employment. Bloom identifies 17 major instances of uncertainty
based on the stock market volatility measure. Baker, Bloom and Davis (2013)
develop a measure of policy uncertainty based on newspaper coverage frequency.
They find that their index proxies for movements in policy-related economic
uncertainty. Specifically, tight presidential elections, Gulf Wars I and II, the 9/11
attacks, the failure of Lehman Brothers, and the 2011 debt-ceiling dispute are
associated with spikes in the index.
Jurado, Ludvigson and Ng [2] develop a measure of uncertainty based on the h-
period ahead forecasting error, where h = 1, 3, and 12 months. Using a comprehen-
sive data set of 132 macroeconomic series they aggregate the forecast errors for each
series to create a macroeconomic uncertainty index. In contrast to Bloom [4], their
analysis finds that there are three major episodes of uncertainty in the 1960–2016
period: 1973–1974, and 1981–1982 recessions, and the Great recession of 2007–2009.
Bali, Brown and Tang [5] create an index of macroeconomic uncertainty based on
ex-ante measures of cross-sectional dispersion in economic forecasts by the Survey
of Professional Forecasters. After controlling for a number of factors, they find a
statistically significant negative relationship between their measure of uncertainty
and future stock returns. Ludvigson, Ma and Ng [6] examine the question of
whether uncertainty is a source of business cycle fluctuations, or an endogenous
response. Their analysis distinguishes macroeconomic uncertainty and uncertainty
about real economic activity from financial uncertainty. They find that financial
uncertainty is primarily an exogenous shock. In addition they find that higher
uncertainty about real economic activity is likely to be endogenous, in response to
business cycle fluctuations.

3. Wavelet analysis

Prior to the work of Ramsey2, the use of wavelets in economic and financial
analysis was largely non-existent. Today, however, wavelet analysis is a well
known, and widely applied tool for any economist who studies time series data.3
The reason for the rapid increase in wavelet based applications is that the wavelet
transform yields a localized decomposition in both time and frequency domain.
This stands in sharp contrast to the traditional Fourier transform often used by
economists that is global in the sense that there is no time component after the

2
See for instance, [7].
3
See [8, 9] for an introduction to wavelet methods in economics and finance.

3
Wavelet Theory

Fourier transform is applied.4 Since the wavelet transform yields a decomposition

that is in localized frequency and time, it has proven to be particularly useful. A
clear application where wavelet methodology benefits the analysis is when applied
to investment decisions over different time horizons.5
The wavelet transform consists of a father wavelet and a set of mother wavelets.
Given a function Φ, the father wavelet for the discrete transform is defined as:

J t 2J ∗ k
ΦJ,k 2 2 Φ (1)
2J
ð
ΦðtÞdt ¼ 1 (2)

The mother wavelets, also in discrete form, are defined as:

j t 2j ∗k
Ψ j, k2 2 Ψ , j ¼ 1, … , J (3)
2j
ð
ΨðtÞdt ¼ 0 (4)

Where J is the number of scales or levels, 2J is a scale factor, and k is the time
domain index. Note that the father and mother wavelets are each indexed by scale
and time. The scale parameter is inversely proportional to frequency.6 The father
wavelet can also be represented as a low pass filter, and the mother wavelets as high
pass filters.7
Wavelet functions transform a time series, f(t), into a series of wavelet coeffi-
cients,
ð
SJ , k ¼ f ðtÞΦJ , k (5)

and,
ð
d j,k ¼ f ðtÞΨ j , k j ¼ 1, … , J (6)

Where SJ , k are the coefficients for the father wavelet at the maximal scale, 2J ;
These coefficients are often referred to as the smooth coefficients. The d j , k , or
detailed coefficients, are the coefficients of the mother wavelets at the scales from 1
to 2J .
Applying the transforms results in a time series of length k of smooth coeffi-
cients at the maximal scale J, and J time series of detailed coefficients each of length
k. If there are 6 scales, the frequency of the first scale is associated with the interval
[1/4, 1/2], and the frequency of scale 6 is associated with the interval [1/128, 1/64].
The number of coefficients differs by scale. If the length of the data series is n,
and divisible by 2J , there are n=2 j d j , k coefficients at scale j = 1, … , J-1. At the

4
Note that while wavelet transforms are often compared to the Fourier transform are they two differ in
a number of fundamental ways. See [10] for a comparison of wavelet versus Fourier transforms.
5
For the relevance of horizon effects see, for example, [11].
6
See [7] 99–103 for a complete discussion.
7
See Ramsey [12].

4
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

coarsest scale there are n=2J dJ , k and sJ , k coefficients. The wavelet variance at each
scale is captured as the wavelet power of each scale.8
A time series f(t) can be represented in decomposed form, known as the
multi-resolution analysis of f(t), as follows:

f ðtÞ ¼ Σk SJ , k ΦJ , k ðtÞ þ Σk dJ , kΨJ , k ðtÞ þ … þ Σk d j , k Ψ j , k ðtÞ þ … þ Σk d1 , k Ψ1 , k ðtÞ

(7)

Using a more convenient summary notation,

f ðtÞ ¼ SJ þ DJ þ DJ 1 þ … þ D1 (8)

The discrete wavelet transform decomposes a time series into orthogonal signal
components at different scales. S j is a smooth signal, and each D j is a signal of
higher detail.
In the case of monthly data, as we use in our analysis, decomposing the series
into six scales (D1-D6) corresponds to 2–4, 4–8, 8–16, 16–32, 32–64, and 64–
128 months. D1 is the shortest scale (highest frequency) component and D6 is the
longest scale (lowest frequency) component. The smooth component (S6) captures
the trend of the original series.
The continuous wavelet transform (CWT) is also a useful approach for gaining
insight into the localized time-scale decomposition of a time series. One advantage
that the CWT has over the DWT is that it produces a powerful visual for detecting
time-scale patterns. The CWT, which is based on continuous variations in the scale
ðλÞ and time components ðtÞ is defined as,
ð þ∞
W ðλ, tÞ ¼ Ψλ , t ðuÞxðuÞdu (9)
∞

where,

1 u t
Ψλ , t ðuÞ  pffiffiffi Ψ (10)
λ λ

The DWT can be viewed as a critical sampling of the CWT with λ ¼ 2 j and
t ¼ k2 j .9
The wavelet power spectrum, or squared amplitude, measures the local variance
of a time series at different scales. It is defined as ∣W ðλ, tÞ2 ∣, and aids our analysis in
terms of understanding how periodic components evolve over time.
In addition to the wavelet power spectrum, we also employ wavelet coherence to
measure the co-movement of two time series across time and scale. To define
coherence we need to define of two other measures, the cross wavelet transform
(XWT), and the cross wavelet power (XWP). The XWT is defined as

W xy ¼ W x ðλ, tÞW y ∗ ðλ, tÞ (11)

The XWP is the absolute value of the XWT, ∣W xy ðλ, tÞ∣. It measures the local
covariance of 2 series at different time scales. The XWP identifies areas in
time-scale space where the two series have high common power.

8
The wavelet power is the amplitude squared.
9
The DWT can also be derived independently, see [12].

5
Wavelet Theory

The wavelet coherence, is defined as:

S S Wxyðλ, tÞ 2
  1 
2
R ðλ, tÞ ¼      (12)
1 2 1 2
S S jW x ðλ, tÞj ∗ S S W xy ðλ, tÞj

Where S is a smoothing operator in time and scale, and 0 ≤ R2 ðλ, tÞ ≥ 1. The

wavelet coherence is similar to the correlation coefficient, and is typically
interpreted as a localized correlation in time-scale space. Note that the coherence
between two series may be high even if the XWP is low.
The applicability of wavelet methodology to investigate uncertainty shocks is
rooted in the fact that market returns reflect an aggregation of investors’ decisions.
Investors do not all share the same time horizon. Wavelet methodology is used so
that localized information that affects returns is not lost.

4. Data

4.1 Sector returns

The equity return data used for our analysis is from the Kenneth French Data
Library (Table 1) [13]. The market portfolio (MKT) is a composite portfolio of all
stocks traded on the NYSE, AMEX, and NASDAQ. The market is divided into 12
industry groups or sectors defined below.

1 NoDur Consumer NonDurables – Food, Tobacco, Textiles, Apparel, Leather, Toys

2 Durbl Consumer Durables – Cars, TV’s, Furniture, Household Appliances

3 Manuf Manufacturing – Machinery, Trucks, Planes, Off Furn, Paper, Com Printing

4 Enrgy Oil, Gas, and Coal Extraction and Products

5 Chems Chemicals and Allied Products

6 BusEq Business Equipment – Computers, Software, and Electronic Equipment

7 Telcm Telephone and Television Transmission

8 Utils Utilities

9 Shops Wholesale, Retail, and Some Services (Laundries, Repair Shops)

10 Hlth Healthcare, Medical Equipment, and Drugs

11 Money Finance

12 Other Other – Mines, Constr, BldMt, Trans, Hotels, Bus Serv, Entertainment

Table 1.
Kenneth French 12 Industry Data Set.

All returns are reported in excess of the risk free rate. The risk-free rate is
measured by the yield on the 1-month T-bill.10 The sample frequency is monthly,
and the sample period is July 1960 to Dec. 2019.11 The sample period includes eight
recessions. These are illustrated in Figure 1. All but three were less than a year in
duration. The 1974–1975 recession was 16 months, this was the time of the first

10
The 1 month T-bill rate used as a risk free rate is calculated by Ibbotson and Associates, and provided
by Kenneth French in his Data Library.
11
The starting period of the sample is determined by the starting period of the uncertainty indexes.

6
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

OPEC price shock, when oil prices quadrupled. The recession starting in July 1981
lasted 16 months. This coincided with Fed interest rate tightening which was
implemented to reduce inflation. Finally the Great Recession of 2008–2009 had a
duration of 18 months. An examination of the cumulative returns of each sector
indicates a high degree of variability across sectors and over time for a given sector.
Figure 2 shows the sectors with cumulative growth that exceeds the market for the
sample period. Figure 3 shows sectors with cumulative growth near or below
cumulative market growth. The sector with the highest cumulative growth over the
sample period is Consumer Non-durables (NoDur) with growth of almost 6400%,
compared with the market as a whole which increased 2378%.The sector with the
lowest cumulative returns is Durable Goods (900%). The effect of the technology
bubble burst (2000–2001), on Telecom, and BusEq returns is salient. The drop is so
precipitous that by the onset of the Great Recession (Dec. 2007), cumulative
returns for these sectors was still below peak (March 2000). They did not reach the
March 2000 peak until 2016. As a whole, Figures 2 and 3 indicate a change occur-
ring with the 2001 recession in that when it comes to cumulative returns, sector
returns appear to part ways. One result is that some sectors recovered quickly from
the 2001 and 2007 recessions and some recovered very slowly.
Figure 4 contains the wavelet power spectrum for market returns. Wavelet
power is a measure of variance local to time and scale. The most striking feature of

Figure 1.
US Economic Recessions, 1960–2020 - NBER Dating.

Figure 2.
Cumulative Returns - High Growth Sectors.

7
Wavelet Theory

Figure 3.
Cumulative Returns - Low Growth Sectors.

Figure 4.
Wavelet Power Spectrum - U.S. Equity Market.

Figure 5.
Wavelet Power Spectrum -Durable Goods.

this chart is that most of the power occurs intermittently at high frequencies. The
wavelet power spectrum for the Durables sector (the lowest growth sector) is
shown in Figure 5, and the power spectrum for the Consumer Non-durables sector
(the highest growth sector) is shown in Figure 6. Both sectors look similar to the
market at high frequencies. At intermediate frequencies (16–32 months) the Dura-
ble goods sector shows high power during the Great Recession, but the the Non-
durables goods sector does not. This is outlined in white for expository purposes.
Consumer non-durables have relatively high power at the 32–64 month frequency

8
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 6.
Wavelet Power Spectrum - Consumer Non-durables.

during the 1970s, while the Durable Goods sector has less variability associated with
this frequency band.12
A set of descriptive statistics for the monthly excess returns (%) is reported in
Table 2. Monthly returns range from a high of 42.6% for Durable goods (Apr.
2009) to a low of minus 32.7% also for Durable goods (Oct. 2008). Skewness is
negative for most sectors, the exceptions being except Durable goods (0.13%);
Excess kurtosis is positive (leptokurtic) for all of the sectors, suggesting that the
distribution of returns has fatter tails than a Normal distribution. It ranges from 1.0
for Utilities to 4.8 for Durables.

4.2 Uncertainty measures

We use three measures of uncertainty in our analysis, macroeconomic and

financial uncertainty from Jurado, Ludvigson, and Ng [2], and economic policy

Sector Mean Std Dev Median Minimum Maximum Skewness Kurtosis

NoDur 0.68 4.24 0.76 21.63 18.3 0.33 2.03

Durbl 0.51 6.15 0.46 32.71 42.62 0.13 4.77

Manuf 0.59 5.22 0.98 29.18 21.07 0.49 2.52

Enrgy 0.63 5.4 0.66 19.01 23.6 0.03 1.23

Chems 0.53 4.55 0.74 25.19 19.71 0.26 2.11

BusEq 0.63 6.36 0.66 26.41 20.32 0.24 1.3

Telcm 0.51 4.59 0.62 16.43 21.22 0.18 1.14

Utils 0.49 3.95 0.64 12.94 18.26 0.15 1.01

Shops 0.67 5.08 0.75 28.83 25.28 0.31 2.4

Hlth 0.67 4.87 0.77 21.06 29.01 0.03 2.29

Money 0.64 5.38 0.91 22.53 20.59 0.38 1.59

Other 0.49 5.34 0.82 29.81 18.85 0.5 2.16

Note: n = 714

Table 2.
Summary Statistics - Sector Returns.

12
The highest power level is shown in red, and the lowest is blue. For the U.S. equity market the highest
power level is 4. For the Durable goods sector the highest power level is 6.8, and for the non-durable
goods sector it is 5.0.

9
Wavelet Theory

uncertainty from and Baker, Bloom and Davis [3]. These are arguably the most
common measures of uncertainty, and they are both updated on a regular basis and
available online.13 JLN and BBD are different measures of uncertainty constructed
using very different methodologies. We summarize both approaches in this section.
JLN define uncertainty for variable yjt as the volatility of the unforecastable part
of the future value of yjt .
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
h i2
y
U jt ðhÞ  E yjtþh E yjtþh jIt jI (13)

where, Eð:jIt Þ is the expectation conditional on information at time t, and h is the

number of time periods for the projection. An increase in the squared forecasting
error of yjt indicates an increase in uncertainty at time of y j at t. The JLN method-
ology computes financial and macroeconomic indexes by aggregating uncertainty
measures of the individual economic series.

Ny
y y
X
U t ðhÞ ¼ w j U jt ðhÞ (14)
j¼1

where w j are the aggregation weights.

JLN used a total of 132 economic series to estimate macroeconomic uncertainty.
The series span the following categories: real output and income, employment and
hours, real retail, manufacturing and trade sales, consumer spending, housing
starts, inventories and inventory sales ratios, orders and unfilled orders, compensa-
tion and labor costs, capacity utilization measures, price indexes, bond and stock
market indexes, and foreign exchange measures.
The financial uncertainty series is comprised of uncertainty measures for 147
financial series. These series include valuation ratios such as the dividend-price ratio
and earnings-price ratio, growth rates of aggregate dividends and prices, default
and term spreads, yields on corporate bonds of different ratings grades, yields on
Treasuries and yield spreads, and a broad cross-section of industry equity returns.
In addition, returns on 100 portfolios of equities sorted into 10 size and 10 book-
market categories are included. The data set also includes excess return on the
market, small-minus-big and high-minus-low portfolio returns, a momentum fac-
tor, a measure of the bond risk premium, and also a small stock value spread.
JLN provide measures of financial and macroeconomic uncertainty based on 1,
3, and 12 month forecast horizons. Our analysis focuses on the one month horizon
series, denoted as h = 1. Their macroeconomic uncertainty series is shown in
Figure 7. In general the peaks of the series align with the NBER recession dates
(shaded areas). The three highest peaks are in the mid-1970’s during the first OPEC
oil shock, the early 1980’s when there were back to back recessions, and the reces-
sion of 2008–2009. Figure 8 shows the wavelet power spectrum for this series. The
power is highest for periods of 32 to 128 months. Unlike the time plot of uncertainty
which peaks at each recession the power spectrum has two basic clusters of uncer-
tainty. It does not distinguish among the first four recessionary periods, and instead
shows one extended period of uncertainty from the early 1970’s to the late 1980’s.
The second period of uncertainty is the Great Recession which is notable for the

13
[2] is available at https://www.sydneyludvigson.com/macro-and-financial-uncertainty-indexes, and
[3] is available at https://www.policyuncertainty.com/index.html.

10
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 7.
Macroeconomic Uncertainty, Jurado, Ludvigson and Ng, (Ph1), horizon = 1 month.

range of scale which is from 8 t0 256 months. The Great Moderation in the 1990’s
(outlined in white) is also apparent as a break in the low frequency power. In
contrast power spectrum for the market returns 4 macroeconomic uncertainty
tends to have low power at high frequencies.
Figure 9 displays the financial uncertainty series for h = 1. The peaks of this
series do not align as closely with recessions as does the macroeconomic uncer-
tainty. For instance there is a noteworthy spike in Oct. 1987 (outlined in red) when
the equity market dropped, and there was no recession. Events such as the 1997
Asian financial crisis, the 1998 Russian financial crisis and the 2000 Tech. bubble
bust are all apparent prior to the 2001 recession. Also, the magnitude of the peaks in
the financial uncertainty index are greater than those of the macroeconomic uncer-
tainty index. Alignment of the peaks of the macroeconomic index with recessions,
and to a lesser extent the financial uncertainty index, is intuitive as forecasting a
turning point is difficult if not impossible. One way useful to think about this is with
regard to asset returns which can be written as,

rt ¼ sign ∗ ∣rt ∣ (15)

It is generally possible to forecast the absolute value of returns but not returns
themselves. The reason is that one cannot forecast the sign.
The wavelet power spectrum or variance (Figure 10) for financial uncertainty is
generally highest at low frequencies. The 1987 stock market crash (outlined in

Figure 8.
Wavelet Power Spectrum - Macroeconomic Uncertainty (EP1).

11
Wavelet Theory

Figure 9.
Financial Uncertainty, Jurado, Ludvigson and Ng, (Fh1), (bottom), horizon = 1 month.

Figure 10.
Wavelet Power Spectrum - Financial Uncertainty (Fh1).

white) is one of several instances where high variance can be also be observed at
medium (8 to 32 month) frequencies.14 The scale of uncertainty is lower from 1960
to 1990 (32–64 months) than it is from 1990 to 2020 (up to 128 months). In effect
low frequency financial uncertainty exists through the sample period.
Baker, Bloom and Davis (BBD) construct a measure of economic policy uncer-
tainty using three major components. For the first component, they search ten
major newspapers and create an index based on the volume of news relating to
economic policy uncertainty. The second component, which is designed to capture
uncertainty in the federal tax code, is derived from Congressional Budget Office
reports on temporary tax code due to expire over the next ten years. The third
component uses the dispersion of opinions among professional forecasters regard-
ing the future of the Consumer Price Index, Federal expenditures and, State and
Local Government Expenditures. The forecasts are from the Philadelphia Federal
Reserves Survey of Professional Forecasters.15 These three components are com-
bined to create the Index of Economic Policy Uncertainty. The index is shown in
Figure 11. Unfortunately the series starts in 1985, so we are unable to study this
series over the same sample period as the JLN uncertainty indices. The BBD index
shown in Figure 11, appears to have a local maxima during each of the 3 recessions,

14
The Wavelet power and coherence analysis was done using MatLab 2020B.
15
https://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-foreca
sters/historical-data/individual-forecasts.

12
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 11.
Economic Policy Uncertainty Index - Baker, Bloom and Davis (EC1).

Figure 12.
Wavelet Power Spectrum - Economic Policy Uncertainty.

but it tends to be volatile with peaks at other important dates such as the two Gulf
wars (1991, and 2003), the debt ceiling debates (2011–2012), the fiscal cliff (2013),
the government shutdowns (1995,2013,2018), and the election of Trump (2016).16
The wavelet power spectrum for the BBD series is shown in Figure 12. High power
is found at the 128 month scale from the mid-1990’s to the present (outlined in
white). There are also a series of high frequency (2–16 months) spikes in the
wavelet power which are not present in the other two uncertainty indices.

5. Uncertainty & the market portfolio

We begin our analysis by examining the relationship between the three measures
of uncertainty, and the market portfolio. Figure 13 shows the coherence between
macroeconomic uncertainty and excess market returns. Red indicates high coherence
and blue indicate no coherence. Coherence is a measure of co-movement between the
two series, similar to a correlation. Note that high coherence does imply high power.
The heavy black lines around the outside of the red areas indicates statistical signifi-
cance at the 95% level of confidence. The frequency is inverted in the coherence

16
[3] provide an annotated version of the index at https://www.policyuncertainty.com/media/US_
Annotated_Series.pdf

13
Wavelet Theory

charts compared with the power spectrum charts. The coherency charts also contain
phase arrows which are explained in Table 3. There are two basic categories of
coherence in Figure 13. Sporadic high coherence at the 8 to 64 month scale, and
prolonged coherence at the 64–128 month scale. The high coherence at the 64–
128 month scales lasts from 1960 until the mid-1980s, breaks for about 15 years
(outlined in white), and reoccurs from 2000 to 2019. The period of the break in
coherence is shorter than the typical time frame known as the Great Moderation
(mid-1980’s to 2007). The phase arrows are pointing left indicating that the two series
are out of phase. The sporadic high coherence at the 16 to 32 month scales occurs in
the middle 1970s, and to a much greater extent during the Great Recession. The phase
arrows indicate that the two series are in anti-phase.
In addition to the monthly returns, we also examine coherence of uncertainty with
the absolute value of market returns that we use as a measure of market volatility.
Figure 14 shows the coherence plot for the absolute value of market returns with
macroeconomic uncertainty. As was the case in Figure 13 there as two periods of high
coherence at a low frequency, but in this instance the scale is lower (32–64 month),
the break (outlined in white) begins in the early 1990s and lasts for about 5 years.
During the Great Recession, uncertainty and market volatility are in phase.17
Figure 15 shows the coherence of the market returns with the financial uncer-
tainty. Coherence occurs at lower scales than the coherence of the market with the

Figure 13.
Wavelet Coherence - Macroeconomic Uncertainty and U.S. Equity Market Returns.

Left arrow: anti-phase

Right arrow: in-phase

Down arrow: X leading Y by 90deg

Up arrow: Y leading X by 90deg

Table 3.
Phase arrow definitions.

17
Note: interpreting the phase as a lead(/lag) should always be done with care. A lead of 90 degrees can
also be interpreted as a lag of 270 degrees or a lag of 90 degrees relative to the anti-phase (opposite sign).

14
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 14.
Wavelet Coherence - Macroeconomic Uncertainty and Absolute Value of U.S. Equity Market Returns.

macroeconomic uncertainty. There is a high degree of coherence in the 1960s and

1970s at the 16–32 month scale, then there is a break (outlined in white) of 20 years
when coherence at these scales is non-existent. Beginning in 2000, coherence is
high once again at the 16–32 month scales. The two series are out of phase during
these periods of high coherence.
The coherence of financial uncertainty and market volatility is shown in
Figure 16. The coherence is high and in-phase throughout the entire sample period
for scales above 32 months. There also are numerous low scale periods when the two
series are in phase and have high coherence.
As shown in Figure 17 the coherence of economic policy uncertainty and market
returns generally occurs at a lower scale then coherence of the two BLN indices.
Statistically signficiant coherence never exceeds the 64 month scale, but it is high
and nearly continuous at the 8 to 16 month scale from 1993 to 2003 (outlined in
white). These periods of high coherence at lower scales appear to coincide with
financial crises. During the Great Recession there is a very clear distinction in
coherence between the 8–16 month scales (2008–2012), and the coherence at the

Figure 15.
Wavelet Coherence - Financial Uncertainty and U.S. Equity Market Returns.

15
Wavelet Theory

Figure 16.
Wavelet Coherence - Financial Uncertainty and Absolute Value of U.S. Equity Market Returns).

Figure 17.
Wavelet Coherence -Economic Policy Uncertainty and U.S. Equity Market Returns.

32 months scale from 2003 to 2018. The phase arrows generally point upwards
indicating a lead–lag relationship.
Figure 18 shows the coherence between economic policy uncertainty and the
absolute value of market returns. Coherence is generally quite low, except for the
128 month scale beginning in the mid -1990s and going to 2019.

5.1 Uncertainty and sector returns

In the previous section, we showed that regardless of the uncertainty measure

employed, there is evidence of high coherence between market returns and uncer-
tainty, and also market volatility and uncertainty. In this section, we examine the
coherence between sector returns and the three measures of uncertainty. Our goal is
to characterize the extent to which uncertainty has impacted individual sectors. To
do this we examine the coherence of each measure of uncertainty with sector
returns. However, uncertainty affects the market and we want to find the

16
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 18.
Wavelet Coherence -Economic Policy Uncertainty and absolute Value of U.S. Equity Market Returns).

relationship between uncertainty and sector returns after removing the relationship
of uncertainty with the market. In order to accomplish this, there is a “before and
after.” We refer to the “after” as the conditional coherence. Conditional coherence
is the coherence of sector returns with uncertainty conditional on the market
returns.18 In addition, to further illustrate the extent to which uncertainty impacts a
sector independently of the impact it has vis-a-vis the market portfolio, we estimate
a rolling regression. The rolling regression is of sector returns against the market
return and the uncertainty index for one or more scales using the discrete wavelet
transform.19 Selection of the scales was based on high conditional coherence of
sector returns and uncertainty measures. The functional form of the regression is,

rssector,t ¼ βs0,t þ βs1,t ∗ rsmkt,t þ βs2,t ∗ U si,t (16)

where U i,t for i ¼ 1, 2, or 3 is a of the measure of uncertainty, and s ¼ 1, ::, 6 is

the scale. The estimation window is 60 months.
As there are three measures of uncertainty and 12 sectors, it would be cumber-
some to show all of the coherence plots for the 12 sectors. Instead, we have chosen to
discuss a subset consisting of six sectors where each sector has at least one period of
high coherence with one measure of uncertainty. While the other sectors may also
have periods of high coherence, including them would add little to our analysis.20

5.1.1 Financial sector returns and uncertainty

The first sector examined is the financial sector. Figures 19–21 show the coher-
ence of the financial sector with all three types of uncertainty both before and after
the market has been partialed out. Most of the coherence with all three types of
uncertainty is subsumed by the market. However, financial uncertainty is one
measure of uncertainty that does matter. As shown, in Figure 20 the right hand side
chart shows several areas of significant conditional coherence. Conditional

18
The partial CWT was estimated using code from [14] updated to run on MatLab 2020B.
19
The rolling regressions were estimated using R. DWT was estimated using the Waveslim package [15]
in R.
20
The other sectors are available from the authors upon request.

17
Wavelet Theory

Figure 19.
Wavelet Coherence -Macroeconomic Uncertainty and the Money Sector.

Figure 20.
Wavelet Coherence - Financial Uncertainty and the Money Sector.

Figure 21.
Wavelet Coherence -Economic Policy Uncertainty and the Money Sector.

18
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

coherence exists for the 32 month scale in the 1970s (circled in white). There is also
a small area of conditional coherence around 1990 at the 16 month scale and it is
also present at the 64–128 month scale beginning around in the mid 1990s. It is
interesting to note that there is no apparent conditional coherence with Economic
Policy Uncertainty in 2010 when Dodd-Frank was passed.
Figure 22 shows the financial uncertainty coefficient estimates (top) and
corresponding t-statistics (bottom) for scales 4 and 5 using the rolling window
regression given in Eq. (16). The scales were chosen based on the conditional
coherence charts. Scales 4 and 5 for financial uncertainty suggest by the presence of
red hot spots that there would be significance for the uncertainty measure. The
dashed lines in the t-stat chart indicate +/ 2. Although both scales are presented,
scale 5 stands out. Scale 5 (32 months) is negative and statistically significant for
three segments of time beginning in the late 1970s. The longest of these three
periods begins in the late 1990s and ends in 2010. Given the large number of shocks
all of which effected equity values, it is interesting to find that the financial uncer-
tainty index had significance in a rolling window regression that includes both the
market and the uncertainty index. Some of the important financial events include
the Asian financial crisis (1997), the Russian financial crisis (1998), the collapse of
Long Term Capital Management (1998), the repeal of the Glass-Steagall Act (1999),
the 2001 recession, and the 2008 recession. The significant negative coefficients for
this time period are an indication that there was sector specific uncertainty over and
above that which impacted the market as a whole.

5.1.2 Energy sector returns and uncertainty

Figures 23–25 contain the coherence of the Energy sector returns with all three
type of uncertainty before (left) and after (right) the market returns are partialed
out. Each of the three right hand side charts display several short periods of high
conditional coherence indicating uncertainty specific to the energy sector. The
longest period of conditional coherence is at scale 6 (64 months) for the Macroeco-
nomic Uncertainty Index (circled in white). There are two small period of high

Figure 22.
Rolling Regression Coefficients -Financial Uncertainty and the Money Sector.

19
Wavelet Theory

Figure 23.
Wavelet Coherence - Macroeconomic Uncertainty and the Energy Sector.

Figure 24.
Wavelet Coherence - Financial Uncertainty and the Energy Sector.

Figure 25.
Wavelet Coherence -Economic Policy Uncertainty and the Energy Sector.

20
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

conditional coherence at the 16 month scale with financial uncertainty. There is

moderate conditional coherence with policy uncertainty from the mid-1980s until
the mid-1990s, but the scale (128 months) is almost completely outside the cone of
influence (COI) and is not statistically significant. The 2014 oil glut that led to a
steep decline in oil prices has a very small area of significance in the conditional
coherence charts. Note also that there is little or no sign of the boom in hydraulic
fracking which began in the mid 1990s, nor the environmental backlash that began
in 2013–2014 in the conditional coherence charts.
Figure 26 shows rolling window regression coefficients at scales 5 (32 months)
and 6 (64 months) for macroeconomic uncertainty. Again, the scales were chosen
based on observations from the conditional coherence charts. Scale 6 is negative and
statistically significant from the mid-1960s until the mid-1970s and clearly shows
the impact of the 1973 OPEC embargo. The uncertainty coefficients for scale 6 are
also negative and statistically significant from 2010 to 2015 and may reflect the
environmental backlash to fracking.
In summary, although the conditional coherence charts show surprisingly little
sector specific uncertainty relating to the OPEC II (1979) oil shocks or the 2014 oil
glut, the DWT regression shows a strong negative sector specific impact.

5.1.3 Telecommunications sector returns and uncertainty

Over the course of the sample period, the Telecommunications Industry evolved
from a heavily regulated monopoly to a more competitive industry with at least six
large firms. In addition, technological changes in communications broadened the
scope of services offered by the industry. This resulted in redefining communica-
tions providers as content providers and making cell phone usage an imperative for
the vast majority of adults. An examination of the coherence charts (Figures 27–29)
does show some periods of sector specific uncertainty. The conditional coherence
chart for financial uncertainty shows high coherence at the 32 months scale
throughout the 1980s (highlighted with white) which is coincident with the
restructuring of AT&T. The conditional economic policy chart shows four high

Figure 26.
Rolling Regression Coefficients -Macroeconomic Uncertainty and the Energy Sector.

21
Wavelet Theory

Figure 27.
Wavelet Coherence -Macroeconomic Uncertainty and the Telecom. Sector.

Figure 28.
Wavelet Coherence - Financial Uncertainty and the Telecom. Sector.

Figure 29.
Wavelet Coherence -Economic Policy Uncertainty and the Telecom. Sector.

22
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

periods of coherence. Two are at the 32 month scale, one in the early 1990s and the
second starting in 2010. There is also high coherence during the Great Recession at
the 8 to 16 month scale. The fourth period of high coherence is at the 64 to
128 month scale beginning in 2005 and ending in 2010.
Based on the conditional coherence charts, rolling regressions were run for both
Economic Policy Uncertainty and Financial Uncertainty indices. Significant coeffi-
cients were found for both indices. Figure 30 shows the uncertainty coefficient
estimates and t-statistics for the regression of sector returns against market returns
and Economic Policy Uncertainty for scales 16 and 32 months. Policy Uncertainty at
scale 32 is negative and statistically significant from 1995 to 2000, and from from
2007 to 2015. The Telecommunications Act of 1996 may be partially responsible for
the large drop in the 32 month coefficient in 1996–1997.
Coefficient estimates for Financial Uncertainty at 16 and 32 month scales are
shown in Figure 31. This is a longer time series than the policy uncertainty index
and it shows a modest negative impact in the 1980s at the 32 month scale. There is a
much larger negative impact at the 32 month scale starting in the late 1990s and
extending until 2018. The significance coefficients are consistent with the explana-
tion that the Telecommunications Sector exhibits sector specific uncertainty.

5.1.4 Business equipment sector returns and uncertainty

Coherence plots for the business equipment sector, which is comprised of com-
puter, electronic and software firms are shown in Figures 32–34. There appears to
be very little conditional coherence for Macroeconomic Uncertainty. The 32 month
scale for Financial Uncertainty shows some coherence in the early 1990’s and from
2000 to 2010. Conditional coherence with Economic Policy Uncertainty is low
except in the 2018–2919 period at the 8 month scale (highlighted in white). This
may be the result of the policy change in favor of repealing net neutrality on the
part of the Trump Administration.
Figure 35 shows the coefficient estimates for Economic Policy Uncertainty at the
8 and 16 month scales. The coefficients for the 16 month scale are negative and

Figure 30.
Rolling Regression Coefficients-Economic Policy Uncertainty and the Telecom. Sector.

23
Wavelet Theory

Figure 31.
Rolling Regression Coefficients-Financial Uncertainty and the Telecom. Sector.

Figure 32.
Wavelet Coherence -Macroeconomic Uncertainty and the Business Equipment Sector.

significant from the late 1990s until 2008. This is a time of rapid growth for the
internet. The tech bubble burst after partialing out the market effect clearly has a
stand alone component. The significant coefficients are consistent with difficulties
encountered when introducing a new technology.

5.1.5 Shops sector returns and uncertainty

There are several instances of significant conditional coherence for the shops
sector (Figures 36–38). Notable is the coherence with Macroeconomic Uncertainty,
and to a lesser extent Financial Uncertainty, at the 64 month scale from the mid
1970s to the late 1980s. The Shops sector, which consists of Wholesale, Retail, and
Some Services, shows very little conditional coherence with the JLN indices after
the late 1980s. This is consistent with the rise and expansion of big box retailers
such as Walmart and Target and the demise of small Mom & Pop stores. Big Guns

24
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 33.
Wavelet Coherence - Financial Uncertainty and the Business Equipment Sector.

Figure 34.
Wavelet Coherence -Economic Policy Uncertainty and the Business Equipment Sector.

are better able to weather uncertainty storms. The rise of internet retail captured by
Amazon’s IPO in 1997 does show up in the conditional coherence for Economic
Policy (highlighted in white). This is suggestive that policy treatment regarding
internet retail mattered, especially considering taxes.
The rolling regression coefficients for the shops sector with economic policy
uncertainty are shown in Figure 39 for 8 and 16 month scales. The uncertainty
coefficients for the 16 month scale are negative starting in 1996 and remain negative
until 2015. This seems consistent with the war between internet shopping and brick
and mortar retail businesses.

5.1.6 Manufacturing sector returns and uncertainty

Coherence plots for the manufacturing sector are shown in Figures 40-42.
There is high conditional coherence with Macroeconomic Uncertainty from 1990 to
2019 at the 128 month scale (highlighted in white). However, at least half of this
coherence is outside the cone of influence (COI). The onset of this uncertainty
coincides with the signing of NAFTA in 1994. There appears to be less conditional
coherence with Financial Uncertainty, although there is a significant patch at the

25
Wavelet Theory

Figure 35.
Rolling Regression Coefficients - Economic Policy Uncertainty and the Business Equipment Sector.

Figure 36.
Wavelet Coherence -Macroeconomic Uncertainty and the Shops Sector.

64 month scale during the Great Recession. Conditional coherence with Economic
Policy Uncertainty occurs in the mid to late 1990s at the 8 to 16 month scale
(highlighted in white). These findings suggest that the market bears the risk to
manufacturing captured by the indices of Macroeconomic and Financial Uncer-
tainty. However, since Economic Policy Uncertainty is showing some hot spots of
conditional coherence this suggests that the market responded to news and infor-
mation regarding this sector, especially the effects of trade on manufacturing. The
stand alone uncertainty that is captured may be associated with policy uncertainty
regarding trade.
Figure 43 shows the rolling regression coefficients for Macroeconomic Uncer-
tainty at the 64 and 128 month scale. The 128 month scale coefficients are negative
and significant throughout the 1970s and 1980s, and from 2000 to 2010. Figure 44
shows the coefficients for Economic Policy Uncertainty at the 8 and 16 month

26
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 37.
Wavelet Coherence - Financial Uncertainty and the Shops Sector.

Figure 38.
Wavelet Coherence -Economic Policy Uncertainty and the Shops Sector.

Figure 39.
Rolling Regression Coefficients - Economic Policy Uncertainty and the shops Sector.

27
Wavelet Theory

Figure 40.
Wavelet Coherence -Macroeconomic Uncertainty and the Manufacturing Sector.

Figure 41.
Wavelet Coherence - Financial Uncertainty and the Manufacturing Sector.

Figure 42.
Wavelet Coherence -Economic Policy Uncertainty and the Manufacturing Sector.

28
Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

Figure 43.
Rolling Regression Coefficients - Macroeconomic Uncertainty and the Mfg Sector.

Figure 44.
Rolling Regression Coefficients - Economic Policy Uncertainty and the Mfg Sector.

scales. The impact of concerns about NAFTA is apparent at the 16 month scale with
negative coefficients in 1996 and ending in 1998.

6. Conclusions

Wavelet methodology, by allowing local features of the environment to be

captured took the lead in our exploration of uncertainty shocks. We examine
changes in coherence between each uncertainty measure and the returns of each
sector both before and after partialing out the coherence of uncertainty with the

29
Wavelet Theory

market portfolio. Rolling regressions were used to identify sector-specific uncer-

tainty that is not captured by the overall market. Such uncertainty was found for the
Money Sector, Energy sector, Telecommunications sector, and Manufacturing sec-
tor. These findings suggest that there are periods when the market reaction to
shocks is not reflecting all the information captured by the uncertainty indices. One
interpretation of our results is that an industry like Telecommunications, Money,
Energy, and Manufacturing undergoing significant technological or regulatory
changes will have a great reaction to shocks than the overall market response
captures. These sectors have a greater sensitivity to uncertainty shocks when the
design of the uncertainty metric is largely macro in orientation.
Our finding that there are episodes of uncertainty when there is increased
comovements across frequency and over time for specific sectors helps paint a more
complete picture of how uncertainty affects the economy through its transmission
across sectors. When local features of the return environment are considered, we
conclude that in the face of uncertainty shocks the market’s knowledge-gathering
role could be improved by introducing uncertainty measures that in terms of
information-gathering are less global and more local. Localized or micro measures
of uncertainty shocks should be of direct relevance to traders and portfolio man-
agers who must respond to such shocks in a ways that are wealth-preserving for
their clients.

Conflict of interest

“The authors declare no conflict of interest.”

Disclaimer

The material presented in thsi Chapter gives the views of the author, and not
necessarily Queens College or the Bank of America.

Author details

Joan Nix1*† and Bruce D. McNevin2†

1 Queens College, New York, USA

2 Bank of America, New York, USA

*Address all correspondence to: [email protected]

† These authors contributed equally.

© 2020 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms
of the Creative Commons Attribution License (http://creativecommons.org/licenses/
by/3.0), which permits unrestricted use, distribution, and reproduction in any medium,
provided the original work is properly cited.

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 Uncertainty and the Oracle of Market Returns: Evidence from Wavelet Coherence Analysis
DOI: http://dx.doi.org/10.5772/intechopen.95032

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