U.S. stock valuations are rising.

One way to measure that is the CAPE ratio, which smooths earnings over a ten year period. This ratio for the S&P 500 hit 28.7 this week, which is in the 94th percentile going back to 1928.

The only periods in history with a higher CAPE ratio were July through October 1929 and February 1997 through April 2002.

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Volatility is low.

One way to measure that is the Volatility Index (or VIX), which measures implied volatility on S&P 500 options. The VIX is currently in bottom 1% of all readings. Since the Friday before the Presidential election, the VIX has declined 54%, its largest 12-week decline in history.

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Valuation and Volatility

Is there any relationship between valuation and future volatility?

Let’s take a look…

Going back to 1928, we can break down the S&P 500 into valuation deciles (0-10% = cheapest valuations, 90-100% = most expensive).

Next, we can compare those deciles to average forward annualized volatility for the S&P 500. What we find is a relationship, but it’s not as linear as one might expect.

In the table below, you can see that the highest valuation decile (which we are currently in) tends to be followed by higher than average volatility over the next one to ten years. Relative to all periods, the biggest differential is four years forward, where on average you see 2.7% higher annualized volatility.

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Higher valuation followed by higher volatility may be intuitive.

What’s not intuitive to most, though, is that the lowest valuation decile also shows above-average forward volatility. This group is littered with data points from 1932-1933, which skews the average numbers higher.

Looking at median forward volatility, we still see above-average forward volatility in the cheapest decile, but much lower than the average figures.

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Why are the lowest valuation periods showing above-average forward volatility? Because stocks tend to be the cheapest during times of economic contraction and/or stress in the markets. During such times volatility is higher and it takes time to transition into a lower or more normal volatility environment. As we know from the value premium, there is no free lunch in buying cheap or distressed assets. The premium return you receive likely exists in part because you are undertaking higher volatility/risk.

But that situation is much more preferable than the opposite end of the spectrum: high valuation periods in which you are taking on higher future volatility without any compensation. As I wrote last year, the higher the starting valuation, the lower the forward returns on average.

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Thus far we have only discussed overall volatility but as we know there are both upside and downside components. When we look at valuation deciles and compare them to average future maximum loss, the picture changes dramatically. Here we can clearly see that forward downside volatility and risk of loss is highest when stocks are most expensive. This downside volatility and risk of loss declines significantly as stocks get cheaper. 

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This should be of some interest to investors as they tend to be more concerned with downside volatility and losses (temporary or otherwise) than anything else.

What does all of this mean today with U.S. stocks in the highest valuation decile and volatility near record lows? Well, investors buying today should expect higher-than-average volatility in those positions going forward with an above-average chance of a drawdown from that buying point. They should also expect a lower-than-average return.

As to the timing of this higher volatility, that is anyone’s guess. No one rings a bell at the top and as we saw in February 1997, an overvalued market can always become more overvalued before problems arise (peak was not until March 2000). That said, the risk/reward in U.S. stocks is clearly tilting more towards the risk side. If nothing else, being aware of that may prevent you from taking on more risk than you can handle.