Dan Passarelli, CEO - Market Taker Mentoring

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On the phone this morning with a reporter from the Wall Street Journal chatting a little bit about the markets and he said he's been working on an article on why no one is buying puts (and he put it a little bit more eloquently than that). Specifically, what he was talking about is the volatility skew, the vertical skew among the stocks in the S&P 500 and the S&P 500 itself. So I got kind of curious and I took a look here at the VX Th, which is the CBOE tail hedge index. And if you look, over the past six months, it's a great deal lower.

In fact, let's expand this out to a year and it's a lot lower than it was a year ago. In fact, it's about two thirds lower than it was at the beginning of this year. Now, what exactly is this index? Well, it measures basically the demand for out of the money puts. So this is not just like a volatility index like the VIX where it's generals volatility.

It's very, very specifically to measure how expensive, basically how expensive, puts are relative to calls, right? And when that skew kind of tips in favor of more demand for puts and puts then being more expensive, it gives us some information from the market that people might be a little bit concerned about the markets, a little nervous and are hedging their investments with buying puts. As our conversation progressed, we ended up talking about some of the reasons why.

And here's what I was looking at. If we look at this chart, this is on Y charts, which is a very good service if you've never used it. The only thing is this chart only goes up to quarter one, but it's a chart of the PE ratio. Let's go to three years here. It's a chart of the PE ratio of the S&P 500. Now, at quarter one it was 22.89. That said, as of August 26, we're still looking about there 22.84 where a year ago it was 31.26.

Now, as far as the estimate, which is the forward twelve month PE ratio of the S&P 500, it's lower. It's 18.37. Although another source that I like to consult a lot, fact set, they put that number at 16.7%. So we don't want to split hairs too much. It's a couple of percentage.

So what is the long term PE ratio of the S&P 500? For the past 4 years it's been 21.92. So we go back and look at this and it's a little tiny bit above it today, less than 1% above it today. But when we're looking at future earnings estimates, it's a little bit lower.And so this tells us a couple of things. It tells us that stocks are not necessarily overpriced when it comes to earnings and when it comes to expected earnings. That means that some of the bad news is probably priced in the market. I think a lot of people know that. That's why they're not out there buying puts and creating all that demand and affecting the skew.

So I hope that helps. Have a great three day weekend.