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Investing, Markets

Why ‘Tobin’s Q’ Should Make You More Cautious Towards The Stock Market Today

After writing “Here’s The Perfect Metaphor For Recent Fed Policy,” I had to pick up a copy of The Dao of Capital. Mark Spitznagel just has a unique way of looking at the markets that really resonates with me.

One thing that really jumped out at me while reading it was Spitznagel’s research regarding Tobin’s Q, (though he calls it, “The Misesian Stationarity Index”). It struck me for two reasons. First, I haven’t seen much research like this elsewhere and second, the opinions I have seen regarding it are all of a dismissive nature.

Just Google “Tobin’s Q” and you’ll find all sorts of pieces proclaiming, ‘Don’t worry about Tobin’s Q,’ and, ‘Tobin’s Q is not an effective way to time the market,’ etc. Actually, both of these sentiments are incorrect.

Spitznagel’s research published in the book shows investors should be worried about the extreme level of Tobin’s Q today for the simple fact that is a very good way to time the market.

But before I get into that I should probably explain what the ratio is. It’s pretty simple, really; the Q-Ratio is just the total value of the stock market (numerator) relative to the total net worth of the companies that comprise it (denominator). The data is provided quarterly by the Fed.

When the Q-Ratio is very low, stocks, as a group, are inexpensive relative to their replacement cost. Conversely, when the ratio is very high, stocks are relatively expensive in this regard.

Critics have suggested this way of thinking about the stock market is outdated. In other words, “this time is different.” And even if they admit that comparing equity valuations to net worth has some value they insist that value does not include timing the market.

However, Spitznagel shows that when you separate the historical record of the ratio into quartiles and compare forward returns to the risk-free rate, stocks have performed very poorly after very high q-ratio readings. They also performed very well after very low q-ratio readings. Once again, it turns out that, “the price you pay determines your rate of return,” is validated by the data.


Additionally, when the Q-Ratio has been very high, as it is today, the size of the subsequent drawdowns were much larger than those following low readings in the ratio. In other words, when stocks become largely very expensive, as they are today (see the chart at the top of this post) we should come to expect large losses.


So if you care about forward returns relative to potential drawdowns, the Q-Ratio is something you probably want to pay very close attention to. Clearly, it has great value in determining this reward-to-risk ratio that is critical to the investment process. And, like other measures, the Q-Ratio is currently suggesting investors are taking a great deal of risk for very little in the way of potential reward.

How the Q-Ratio comes to be so skewed is different topic altogether and something you’ll learn in reading the book. But here’s a hint. And if you need further incentive to pick up a copy, Spitznagel also includes a couple of simple strategies built around the Q-Ratio that handily beat a buy-and-hold approach.

Economy, Investing, Markets

No — This Chart Doesn’t Prove This Is The Most Hated Bull Market

All it proves is that the wealth gap is, indeed, growing ever wider. Gallup recently released the results of a poll many are using to claim, “See! I told you this was the most hated bull market of all time!” It shows that only 52% of Americans currently own stocks, tied for the fewest on record (chart above).

Let’s set aside the fact that this is poll and many Americans don’t realize how much they currently have invested in the stock market via retirement plans. Let’s just focus instead on the actual data from the Fed which shows equity ownership as a percent of household financial assets near all-time highs. If they do, in fact, hate stocks, they certainly aren’t putting their money where their mouths are.

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Now this still doesn’t address what percent of Americans actually own stocks. It just aggregates all of their financial assets and tells us what share is allocated to the stock market. But it certainly suggests that Americans don’t hate the stock market. In fact, as a group they have never preferred stocks to cash more than they do today.

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And if you’re looking to understand why Americans as a group might not feel as wealthy or optimistic about their personal finances as they have in the past, despite the Fed’s apparent success in boosting the prices of risk assets, you might want to take a look at another poll. The Atlantic reports:

The Fed asked respondents how they would pay for a $400 emergency. The answer: 47 percent of respondents said that either they would cover the expense by borrowing or selling something, or they would not be able to come up with the $400 at all. Four hundred dollars! Who knew?

If 47% of Americans don’t even have $400 in savings is it any wonder they aren’t buying stocks? But if they actually had $400 to their names, that Fed data referenced above suggests it would most likely be invested in the stock market, not in cash, that latter asset class truly being the most hated in history.


It’s Time To Put An End To The “Most Hated Bull Market” Meme

Investing, Markets

Tech Bubble 2.0 Is Bursting

Rumors of the demise of tech bubble 2.0 started percolating last year. Q1 of this year proved it wasn’t an exaggeration. Last month the Wall Street Journal reported that funding for startups fell 25% during that period, the largest decline since tech bubble 1.0 burst.

For many of the hottest startup communities outside of Silicon Valley it was even worse. According to Quartz, Seattle saw funding fall 28.5%. Denver-Boulder saw a 40.93% decline and in Austin it was worse still. The hottest of hot spots was down 63.5% in Q1.

Part of the problem is startups just got way too overvalued, as celebrity VC Peter Thiel recently told Bloomberg. And a rising number of failures (as a product of sky-high burn rates and silly business models) has changed investor risk appetites in the space. VC Bill Gurley recently wrote:

In late 2015, many public technology companies saw a significant retrenchment in their share prices primarily as a result of a reduction in valuation multiples. A high performing, high-growth SAAS company that may have been worth 10 or more times revenue was suddenly worth 4-7 times revenue. The same thing happened to many Internet stocks. These broad-based multiple contractions have an immediate impact on what investors are willing to pay for the more mature private companies.

Late 2015 also brought the arrival of “mutual fund markdowns.” Many Unicorns had taken private fundraising dollars from mutual funds. These mutual funds “mark-to-market” every day, and fund managers are compensated periodically on this performance. As a result, most firms have independent internal groups that periodically analyze valuations. With the public markets down, these groups began writing down Unicorn valuations. Once more, the fantasy began to come apart. The last round is not the permanent price, and being private does not mean you get a free pass on scrutiny.

At the same time, we also started to see an increase in startup failure. In addition to high profile companies like, Quirky, Homejoy, and Secret, numerous other VC-backed companies began to shut their doors.

So valuations got too high, more and more companies have failed to live up to the hype and now valuations are falling. It’s the classic boom-bust cycle at work that should be all too familiar to anyone whose been around longer than just the past boom (aka, “half”) cycle.

Strangely, however, amid falling valuations and a significant decline in funding, Venture Capital firms are doing an amazing amount of fundraising themselves. In fact, during the massive decline in funding in Q1, VC’s did a record amount of fundraising – so where’s the disconnect? The WSJ reports today:

Mr. Rabois says the record fundraising actually is a bearish sign. Winter is coming, he says, and venture capitalists know it. “One of the reasons people are raising all these funds isn’t because they want the money, but because they believe their own metrics are inflated at the moment, and they want to get that money before companies in their portfolios start crashing and burning,” he said.

So it’s just a last grab for easy cash before it all dries up, or, ‘crashes and burns.’ VC’s clearly see the writing on the wall. Startups see it, too. They’re starting to cut back in an attempt to avoid getting caught in the rising tide of startup failures. This is where those incredible burn rates meet falling liquidity and the balance sheet fires really start to rage. Gurley again:

Layoffs have also become more prevalent. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the tough decision to reduce headcount in an attempt to lower expenses (and presumably burn rate). Many modern entrepreneurs have limited exposure to the notion of failure or layoffs because it has been so long since these things were common in the industry.

The point Gurley makes is an important one: Many founders today weren’t around for the bursting of tech bubble 1.0 and so don’t understand how quickly or painfully it can all go south. And they now face a new challenge they can’t have imagined even six months ago: falling employee morale. Startup employee, Anna Weiner writes:

Our culture has been splintering for months. Members of our core team have been shepherded into conference rooms by top-level executives who proceed to question our loyalty. They’ve noticed the sea change. They’ve noticed we don’t seem as invested. We don’t stick around for in-office happy hour anymore; we don’t take new hires out for lunch on the company card. We’re not hitting our KPIs, we’re not serious about the OKRs. People keep using the word paranoid. Our primary investor has funded a direct competitor. This is what investors do, but it feels personal: Daddy still loves us, but he loves us less.

We get ourselves out of the office and into a bar. We have more in common than our grievances, but we kick off by speculating about our job security, complaining about the bureaucratic double-downs, casting blame for blocks and poor product decisions. We talk about our IPO like it’s the deus ex machina coming down from on high to save us — like it’s an inevitability, like our stock options will lift us out of our existential dread, away from the collective anxiety that ebbs and flows. Realistically, we know it could be years before an IPO, if there’s an IPO at all; we know in our hearts that money is a salve, not a solution.

With falling valuations, reduced funding, the IPO market shut down, and growing layoffs as the easiest tool to address problematic burn rates, just this sort of morale challenge must be growing across the startup universe. And once the bust reaches the employee level the confidence game is up.

The gold rush is over. As Weiner writes, “ours is a ‘pickax-during-the-gold-rush’ product, the kind venture capitalists love to get behind.” And boy did VC’s get behind these sorts of companies. Just take a look at the list of the most highly-valued startups and think about how many of these business models have leveraged the growth in mobile/apps/smart-phones:

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Now think about how many highly-valued startups not on this list were also built around the mobile boom. This was the startup gold rush of the past decade that was kicked off when Steve Jobs introduced the first iPhone back in June of 2007. And VC’s know all about getting rich during the gold rush. As my friend Jeff recently wrote:

How do you get rich in a gold rush? Not by looking for gold – by selling maps and shovels. You’ll make an absolute fortune selling maps and shovels in a gold rush. But your growth rates and business might not be sustainable in the long term.

VC’s certainly made an ungodly fortune during the recent boom. Now that it’s ending we’ll soon find out just how how sustainable these “pickax-during-the-gold-rush” business models really are. And considering the fact that the FANGs and their ilk have sold as many maps and shovels as anyone, it will probably be a public market story as much as a private market one.

Investing, Markets

This Indicator Is Still Flashing A Bear Market Warning

The NYSE just released the margin debt numbers for March and, considering the rally in stocks we’ve seen, it wasn’t much of an uptick. In fact, the nominal level of margin debt remains well below its 12-month average.


The 12-month rate of change, which is pretty tightly correlated with stocks’ same rate of change, is also still negative.


Now this sort of a downtrend in margin debt doesn’t always lead to a bear market but let’s put it into some context. Not only is margin debt now in a downtrend, it’s coming off of the highest absolute (top chart) and relative (chart below) highs ever seen.


And if you think if margin debt as a simple indicator of potential supply and demand for stocks (when borrowing is low there is great potential demand and vice versa), this should have you worried about another bear market. And the statistics bear this out.

When margin debt has reached relative extremes it has been a very good indicator of, in the words of Warren Buffett, broad investor, “fear and greed.” To demonstrate, when financial speculation relative to the overall size of the economy has been very low, forward 3-year returns have been very good and vice versa.


What’s important to note today is that margin debt is now in a downtrend and its massive relative size suggests returns over the next 3 years will be very poor. In other words, based solely on this one measure, buying stocks today presents investors with a great deal of risk for very little potential reward.


‘The Media Follows Mood’

My friend, Peter Atwater, likes to say, “media follows mood.” Well, here’s a terrific example:

Six weeks ago, as the stock market was only just beginning to rise out of its February lows after a fairly brutal selloff, the Wall Street Journal was abuzz with stories criticizing corporations’ widespread and growing use of “pro forma” financial reporting. These stories grew in number as the month went on:

Mind the GAAP, Even for Blue Chip Stocks

Investing Red Flag: Pro Forma Results and Share Price Performance

SEC Signals It Could Curb Use of Adjust Earnings Figures

Today, in contrast, after stocks have now run higher for over 50 trading days since their lows, the paper runs a bullish story on Facebook ahead of its earnings announcement. Funny, there’s no mention, however, that Facebook is one of the most egregious examples of aggressive “pro forma” reporting.

To demonstrate, the gap between the company’s GAAP earnings and its “pro forma” earnings last year amounted to no less than a 77% overstatement ($1.29 GAAP versus $2.28 pro forma). The article also fails to mention that the forward price-to-earnings measure the author references, in claiming, “Facebook looks like a bargain,” is based on these inflated “pro forma” earnings.

It’s pretty fascinating how quickly skepticism can fade away simply as a result of higher stock prices. And I guess I probably didn’t really need to read beyond the, “this time is different,” headline to know how the piece would go.