We're within striking distance of the all-time highs in stocks. Are U.S. equities overbought?
The short answer is ... not yet (especially if we're talking about the S&P 500).
Digging a little deeper, the longer, more comprehensive answer lies in measures of stock market volatility. This is a tricky one. But stick with us. The implications are deeply revealing.
First, some basic definitions:
- Realized Volatility = Historical Volatility (of an asset over a given time period)
- Implied Volatility = Future Volatility (the volatility that investors expect in the future based on current options market positioning)
In short, if investors expect volatility to rise in the future, you would see higher implied volatility than realized volatility (and vice versa). This is called the volatility premium (where implied volatility exceeds realized volatility) or discount (if implied is below realized).
Obviously, the real money in financial markets is made by selling things that are overbought and buying things that are oversold. Right now, as seen in the Chart of the Day below, S&P 500 volatility (over a 30-day period) is trading at a 25.8% premium. This means that investors are really concerned about markets near all-time highs and downside risks, like valuations, so their expectations of future volatility went up.
But this is a kneejerk reaction that is most likely overdone. Basically, when the premium stretches to these levels, it comes back to more normalized levels. Lower volatility is bullish, as formerly fearful investors capitulate and buy stocks.
Conversely, look at the discount in Energy stocks (XLE) of -26.5% (again, over a 30-day period). This suggests the recent run-up in Energy stocks (up +9.4% in the quarter-to-date) is probably overdone.
Again, this implies investors have exhuberantly piled into the Energy stocks. Volatility and downside risk is in the offing. That's also why Hedgeye CEO Keith McCullough issued an overbought signal in the Oil & Gas Exploration & Production ETF (XOP) in Real-Time Alerts yesterday.
so, What does it all mean?
It means that on a relative basis, the S&P 500 is a buy versus Energy stocks (or the Nasdaq). Add-in our positive outlook for the U.S. economy and you get a recipe for equity markets to head higher.
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