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P/E to implied volatility ratio signals that investment mood is becoming too euphoric

The U.S. Presidential election has been critical for U.S. equity market performance, as it had a profound impact on market expectations for a swift ‘reflation’ of the U.S. economy, targeted deregulation, and looser fiscal policy. Positive market sentiment has not only pushed major equity indices higher, but equity valuation as well, raising concerns that the market is overheating.

It is true that on a number of widely tracked valuation metrics the U.S. equity market looks expensive, even though the low level of interest rates is providing some leeway. A less followed metric that has also been signaling that the market is rich, or, at least complacent, is the S&P 500 12-month trailing and/or 12-month forward P/E to implied equity volatility (VIX Index) ratio. Historically, when the ratio was higher than one standard deviation from its long term mean, subsequent equity market performance was weak.

The report explores whether the specific metric contains information about future equity market performance.