In investment management we often use information gleaned from ratios to try and establish (within the limits of probability) where we are in a given market cycle.  Most of the time these ratios are financial in nature, comparing price to some other metric that, over long periods of time, should normalize around an average value.  Common examples include the price/earnings ratio, as well as price/sales, price/book value and so on.  Each of these may be applied to examine the future prospects for returns over a reasonable time horizon based on where the ratio currently sits with respect to it’s long-term average value.

This concept of valuation is best illustrated by imagining a situation where you expect an asset to be worth $1,000 15 years from now.  If you have to pay $300 for it today your expected annual return is about 8.4%, if you pay $600 your expected annualized return is 3.5%, and if you pay $900 your annualized return is a meager 0.7%.  That’s what valuation is trying to get at.  It’s not that we’re trying to predict market crashes; more realistically, valuation gives us insight into prospective returns and helps us to determine the relative attractiveness of an investment.

Of course, a ratio can compare the relative values of any two data points – including between ratios themselves – and the analysis can examine how these ratios change over time.  Take, for example, Deutsche Bank’s recent examination of the PE/VIX ratio, what we are calling the ratio of “value to fear.”  The PE (aka price/earnings) component we wrote about above; it’s a measure of valuation.  The VIX, on the other hand, is a measurement of the implied volatility of the S&P 500 based on a set of S&P 500 index options.  In other words, it answers the question “how volatile (or risky) do traders expect the S&P 500 to be in the near future?”  At it’s core, the VIX is about risk attitude.

So, when we look at a ration like PE/VIX, we’re trying to assess whether or not the valuations and investor attitudes are in sync, or whether there is material dissonance.  Making this comparison creates a wide range of potential results, but in general, there are three qualitative states the ratio could take:

1.)  The ratio is SMALL.  This happens when valuations are low (implying high future returns) and the VIX is high (meaning there is strong consensus that the markets are risky).  This is a PANIC phase that we so often see at market bottoms; there are excellent values to be had, but most people can’t bear to buy.  Think 2003 and 2009, times when those same people who couldn’t bear to buy really should have.
2.)  The ratio is NEUTRAL.  This happens when the PE and VIX are in-line with each other.  It says nothing about the valuations or risk expectations in and of themselves, only that they are in HARMONY.  In this state, when PEs are high so too is perceived risk; when PEs are low so too is perceived risk.  This most often occurs during the mid-stages of cyclical bull markets.  Technically speaking, it also must happen in a bear market, but as bears develop much more rapidly than bulls, the more common variation is mid-stage bull.
3.)  The ratio is LARGE. When valuations are high (implying low future returns), and the VIX is low (meaning everyone is ignoring risk), we get EXUBERANCE.  This state appeared in 1992, 1999-2001, and 2005-2007, times when people couldn’t bear to sell, but they really should have.

Now, would you care to venture a guess which historically outlying state the ratio is in right now?  Go ahead…we’ll wait…

Deutsche’s report showed a 1.66 ratio – an indication of historically high EXUBERANCE, bordering on full-on MANIA.  Here’s their chart, as of June 6:

Now, let’s be clear on one thing.  This doesn’t mean that there’s going to be a market crash tomorrow or this month or even this year.  But it does mean that right now there exists a potent and historically lethal combination of extended values and opiate-esque complacency.  It also means that, in the scenario where we don’t get a reversion to historical valuation levels over the next few years, the best scenario we can hope for appears to be that increasing valuations will be met with increasing volatility.  And volatility in and of itself, dear reader, can seriously mess you up if you’re planning for retirement.

“But wait,” we already hear you saying.  “How can volatility hurt me even if asset prices are rising?  How is that even possible?”

Here’s a link to an article that explores why volatility is far more important to retirement success that people imagine.  If you’ve ever asked yourself the above question, then you need to read it now!

UPDATE:  The original article was written in early June when Deutsche Bank released their research note.  Since then, things have not gotten better.  According to multpl.com, as of September 21st, the trailing twelve months PE ratio was 19.77 and according to the CBOE, the VIX sat at 12.11.  In other words, the ratio is currently sitting at 1.63, just below the previous all time high, and still fully in the “mania” zone.