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How to Value the Stock Market Using the Equity Q Ratio

June 04, 2012 | About:
Inoculated Investor

Greenbackd

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Mark Spitznagel, CIO of Universa, released in May a prescient white paper called “The Austrians and the Swan: Birds of a Different Feather” in which he discussed the theory behind the “Equity Q Ratio,” a variation of Tobin’s Q ratio, and the expected returns to the market from various levels of Equity Q Ratio.

Tobin’s Q ratio is the ratio between the market value of the stock market and against the aggregate net worth of the constituent stocks measured at replacement cost.

It can be defined to include or exclude debt. We exclude debt for ease of calculation and refer to it in this form as “Equity Q.”

Spitznagel observes that the aggregate U.S. stock market has suffered very few sizable annual losses (which he defines as “20% or more”). By definition, we can categorize such extreme stock market losses as “tail events.”



However, when the Equity Q ratio is high, large losses are “no longer a tail event, but become an expected event.”



Equity Q ratios over 0.9 lead to some very ugly results. So where are we now?



Ugly.

About the author:

Greenbackd

My name is Ben C. and I am 2nd year MBA candidate at the Anderson School of Business at the University of California- Los Angeles. I have a BS in Economics from the Wharton School of Business at the University of Pennsylvania. Before coming to Anderson I worked as a generalist equity research analyst for Right Wall Capital, a long-short equity hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund located in Rye Brook, NY. This past summer, I worked for West Coast Asset Management as a research analyst. West Coast, which was co-founded by Kinko’s founder Paul Orfalea, is run by well-known value investors Lance Helfert and Atticus Lowe.



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