In our last blog post, we noted that consumer confidence has fallen in recent months. Investors’ confidence in the stock market is no different. Investor confidence has faded over the past few months, evidenced by high volatility and low valuations.

On their own merits, these two metrics provide invaluable insight into the equity market. Take that one step further and they can be combined to gain even more insight in the form of the Value-to-Fear ratio or the Forward PE/VIX ratio.

The numerator, the forward price-to-earnings (PE) ratio, is a valuation metric that measures the price of a stock or index relative to its estimated earnings for the next 12 months. The higher the forward P/E ratio the higher the premium investors pay for the stock’s future earnings. The denominator, the CBOE Volatility Index (VIX), gauges investors’ expectations of equity market volatility in the 30 days ahead. Abnormal price swings in the equity market result in subsequent movements in the options market and reflect higher volatility and therefore a higher VIX.

The idea behind the Value-to-Fear ratio is simple. When the ratio is elevated, valuations are high and expected volatility is low. Investors are ignoring risk, and we get exuberance. We argue that such a situation tends to precipitate market selloffs or pullbacks. This occurred in 1992, 1999-2001, 2005-2007 and 2020, when investors saw only good times ahead for equities, fuelling a manic market. Moreover, low valuations and a high VIX, produce a suspiciously low indicator, often indicative of a market bottom.

Prior to the pandemic high valuations and relatively low volatility produced a very complacent market. The outbreak of the pandemic sparked a dramatic selloff (low valuations and high VIX) and sent the ratio to near historic lows. In the wake of the covid induced selloff, central banks deployed ultra-accommodating monetary policy, pumping liquidity into financial markets like never seen before. As a result, stock valuations and premiums inflated to historic levels.

Now, in the face of 8.5% inflation, the time has come for central banks to unwind uber-accommodative monetary policy in order to temper price levels. As a result, we have seen valuation come off and volatility increase. Pair that with the ongoing Russian-Ukrainian war and the value-to-fear ratio has quickly shifted lower. Although this indicator is far from infallible, it should be watched more closely as we move forward.

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