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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Critics have suggested this way of thinking about the stock market is outdated.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


What Hath The Fed Wrought?

It’s Fed week once again and once again the group has decided to leave interest rates unchanged. This, despite the fact that, with core inflation running at just over 2% and jobless claims at their best levels of my lifetime, they have clearly met their dual mandate. In fact, they met these targets a long time ago. By any measure, the jobs market is very strong and, with core inflation rising, it’s hard to argue deflation poses any real threat whatsoever.

If their goals have been met, why has the Fed been so hesitant to abandon this emergency interest rate policy? I think it’s very simple. They are worried about spooking the markets and thus damaging the wealth effect they so aggressively and explicitly targeted over the past seven years.

The bigger (rhetorical) question, however, is this: In maintaining emergency policy for so long, what hath the Fed wrought? It only took a couple of years of emergency-level interest rates to inflate the housing bubble. After seven years (and counting) of emergency-level rates what hidden (or not so hidden) risks or mispricings driven by malinvestment have accrued this time?


The Greatest Money Manager Alive Attributes The Majority His Success To Just This One Thing

Economy, Markets

Even More Signs Of A Possible Reversal In The Wealth Effect

“If you build a bridge it has to reach the other side. So I think a bridge that relies on wealth effects, you better hope that you got enough growth to justify the asset price increase which created the wealth effect in the first place. So there is some sort of virtuous cycle that gets kicked off which becomes self-fulfilling over time. The alternative is you kick off the wealth effect now, but over time people realize the wealth ain’t coming and then you have an asset price adjustment.” –Raghuram Rajan, current head of the Reserve Bank of India and former chief economist at the IMF

There is no doubt the Fed achieved its goal of boosting the prices of risk assets over the past several years. Whether the Fed was able to create a, “virtuous cycle,” of growth that validates the gains in stocks is another question entirely. From the looks of equity values relative to their earnings, I’d have to say it now appears that, just a Rajan suggested, “the wealth ain’t coming.”

This is most evident in the recent fortunes of the most wealthy. CEO pay is falling at the fastest rate since the financial crisis. This is mainly because corporate earnings and profit margins are falling and the efforts of CEO’s and CFO’s aimed at engineering better financial results just aren’t enough to overcome these headwinds.

In addition to the public executive suite, it appears startup founders and their venture capitalist backers are feeling the heat from a broad shift in risk appetites.

This doesn’t just affect Silicon Valley. Startup hotbeds in places like Seattle, Austin and others are even feeling more pain right now than the Bay Area.

Still, Silicon Valley is the single largest startup market on the planet by far and the weakness there is already apparent in their real estate market.

It’s not just the ultra-high-end of that real estate market that’s feeling pressured. Real estate prices broadly declined in San Francisco last month.

On the other side of the country, the pressure on the wealthy is coming from troubles in investment banking. Like the troubles in VC, this is mainly due to a broad shift in risk appetites (mainly in the credit market’s unwillingness to fund deals).

It appears hedge fund managers are also feeling the pinch of waning risk appetites.

In a recent piece, I noted the weakness in market for real estate in the Hamptons as a direct result of this pressure on the wealth there. But it appears they may be selling their winter homes, too.

Beyond real estate, there’s a common theme now of weakening sales across virtually every luxury retailer, as well.  I recently wrote a bit about Sotheby’s issues. LVMH had a similarly rough first quarter.

…as did Burberry.

If the Fed’s theory regarding the wealth effect is correct the weakness at the very high-end that we are now seeing could be a very good leading economic indicator. And it might not take long to see this weakness, “trickle down.” In fact, it may already be apparent in auto sales. As a direct beneficiary of zero-percent interest rates, this has been a bright spot for the economy… until now.

Car makers now have so much inventory, both new and used, they are getting desperate to offload it.

Weakness in autos is also starting to show up in credit, which has underpinned the entire boom in the sector.

All in all it seems there is reason to worry about the consequences of the Fed-engineered wealth effect in recent years. If it is now unwinding, “an asset price adjustment,” as Rajan suggested, may now be looming.


Is America Insolvent? Are You An Idiot For Even Asking?

The latest issue of Time magazine is causing quite the to do. It leads with an article titled, “Make America Solvent Again,” written by Jim Grant.

Economist Paul Krugman is already out ripping the piece, mainly via ad hominem attack on the author:

Investment Adviser Barry Ritholtz perpetuates a similar ad hominem on the publication itself along with repeating Krugman’s genetic fallacy in a similar post:

At the same time, you have former Fed insider, Danielle DiMartino Booth, with a plea this week very similar to Grant’s:

And the greatest money manager alive has been singing Grant’s song for quite some time now:

So who do you believe?

Forget my own logical fallacy (appeal to authority) here for a minute. Personally, I find the sheer volume of disdain for this article alone to be very troubling. It’s a shame that what could be the most important issue facing our nation can’t even be discussed openly among adults without immediately devolving into personal attacks. But the fact that it does suggests to me these critics must feel a great deal of insecurity about their own position. Why else would they give up on it and resort to these sorts of epithets and fallacies so quickly?