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The “Calm Premium” : Aura Solution Company Limited

The recent U.S. equity rally has coincided with a drop in volatility. But can that continue? Aura Solution Company Limited discusses.

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While the equity rally seems to have at least temporarily stalled, stocks remain near three-month highs. The rebound in equity prices has been driven by a sharp and relentless bout of multiple expansion. In other words, investors are willing to pay more for each dollar of earnings. In the 45 days between the market’s low on Christmas Eve and March 1st, the S&P 500’s price-to-earnings ratio (P/E) expanded by just under 20%.


As a result, U.S. equities are once again trading at a premium to their history and virtually every other equity market. At over 18 times trailing earnings, the market is trading at a 4% premium to its post-crisis average, a 10% premium to its long-term average and a 25% premium to the rest of the world (see Chart). In an environment in which earnings growth is likely to slow, valuations will determine whether stocks can hold or even add to their already prodigious gains.


Low vol, high multiples

The rally in equities has been accompanied by a sharp drop in volatility. In early March the VIX Index fell below 14, the lowest point since early October. The same phenomenon is evident in fixed-income markets. The MOVE Index, which tracks volatility in bond markets, also recently hit a five-month low.


As I’ve discussed in previous blogs, since the end of the financial crisis equity multiples have tended to move in the opposite direction to market volatility. While this seems intuitive, it is a relatively new phenomenon. Prior to 2010 there was no correlation between market volatility and equity valuations.


For example, the late 1990s were a time when valuations and volatility were both well above average. Between 1998 and 2000 the P/E (trailing 12 months) on the S&P 500 averaged around 27x. Interestingly, historically high multiples coexisted with elevated volatility, with the VIX Index averaging 25.5, 30% above the long-term average.


Following the financial crisis, periods of high multiples and high volatility have become less frequent. Beginning in 2010 the level of the VIX has explained approximately 35% of the variation in the S&P 500 P/E. For every one point reduction in the VIX the P/E multiple on the S&P 500 has been approximately 0.25 higher.


This dynamic helps explain why valuations expanded so relentlessly in late 2016 and 2017. However, as volatility began to rise in February of 2018 historically high multiples became harder to sustain. Should volatility continue to revert back towards its long-term average, roughly 19 on the VIX, today’s valuation premium looks vulnerable.


What does this suggest for the remainder of 2019?

The recent drop in volatility is consistent with the easing in financial conditions, but inconsistent with greater economic uncertainty and a slowing economy. For valuations to stay high, financial conditions need to remain easy. Otherwise, a rally predicated on rapidly rising multiples may fade just as quickly.


Choose your Country or Region

Africa and Middle East

Kaan Eroz

Managing Director

Aura Solution Company Limited

E : kaan@aurasolutioncompanylimited.com

P : +90 532 781 00 86

Aurapedia Desktop :https://www.aurapedia.org/kaan-eroz-wikipedia

Aurapedia Mobile :https://www.aurapedia.org/kaan-eroz-mobile-view

________________________________________

Asia Pacific

Mark Brewer

Managing Director

Aura Solution Company Limited

E : brewer@aurasolutioncompanylimited.com

P : +66 993034 369

________________________________________

Europe

Antonio Sanguedolce

Managing Director

Aura Solution Company Limited

E : antonios@aurasolutioncompanylimited.com

P : +39 391 187 6270

________________________________________

Latin America and the Caribbean

Joseph Aidamouny

Managing Director

Aura Solution Company Limited

E : AIDAMOUNY@aurasolutioncompanylimited.com

https://www.aurasolutioncompanylimited.com/latam

P : +961 70 322 305

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Aurapedia Mobile : https://www.aurapedia.org/joseph-aidamouny-wikipedia-mobile

________________________________________

India

Vinod Prasad

Managing Director

Aura Solution Company Limited

E : vinod@aurasolutioncompanylimited.com

W: www.aurasolutioncompanylimited.com/india

P : +91 98608 54929

Aurapedia Desktop : https://www.aurapedia.org/vinod-prasad

Aurapedia Mobile : https://www.aurapedia.org/vinod-prasad-mobile-version



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