Fat Tails: How The Equity Q Ratio Anticipates Stock Market Crashes

Hedge funds trail S&P 500 by 677 for first 90 days of 2013

By: greenbackd

In The Equity Q Ratio: How Overvaluation Leads To Low Returns and Extreme Losses I examined Universa Chief Investment Officer Mark Spitznagel’s June 2011 working paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes (.pdf), and the May 2012 update The Austrians and the Swan: Birds of a Different Feather (.pdf), which discuss the “clear and rigorous evidence of a direct relationshipbetween overvaluation measured by the equity q ratio and “subsequent extreme losses in the stock market.”

Spitznagel argues that at valuations where the equity q ratio exceeds 0.9, the 110-year relationship points to an “expected (median) drawdown of 20%, and a 20% chance of a larger than 40% correction in the S&P 500 (INDEXSP:.INX) within the next few years; these probabilities continually reset as valuations remain elevated, making an eventual deep drawdown from current levels highly likely.”

In his 2011 and 2012 papers, Spitznagel describes the equity q ratio as the “most robust aggregate overvaluation metric, which isolates the key drivers of valuation.” It is also useful in identifying “susceptibility to shifts from any extreme consensus,” which is important because “such shifts of extreme consensus are naturally among the predominant mechanics of stock market crashes.”

He observes that the aggregate US stock market has suffered very few sizeable annual losses (which Spitznagel defines as “20% or more”). Extreme stock market losses are by definition “tail events” as Figure 1 demonstrates.

Figure 1 shows how infrequently large drawdowns occur. However, when the equity q ratio is high, large losses are “no longer a tail event, but become an expected event.”

Figure 3 shows the magnitude of potential losses at various equity q ratios. In the last bucket (equity q > 0.9), the expected (median) drawdown is 20 percent, with a 1/5 chance of a greater than 40 percent correction in the S&P 500 (INDEXSP:.INX) within the next few years. Spitznagel describes Figure 3 as “[t]he best picture I have ever seen depicting the endogenous risk control to be had from Benjamin Graham’s margin of safety principle (which insists on cheapness to conservative fundamental assumptions in one’s equity exposures, and thus provides added protection against errors in those assumptions).

Equity q ratios over 0.9 lead to some very ugly results. So where are we now? I’ll discuss it later this week.

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About the Author

My name is Tobias Carlisle. I am the founder and managing member of Eyquem Investment Management LLC, and portfolio manager of Eyquem Fund LP. Eyquem Fund LP pursues a deep value, contrarian, Grahamite investment strategy based on the research featured in Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (hardcover, 288 pages, Wiley Finance, December 26, 2012), and discussed on Greenbackd. I have extensive experience in activist investment, company valuation, public company corporate governance, and mergers and acquisitions law. Prior to founding Eyquem, I was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions I have advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam, ranging in value from $50 million to $2.5 billion. I am a graduate of the University of Queensland in Australia with degrees in law and business (management). Contact me I can be contacted at greenbackd [at] gmail [dot] com. I welcome all feedback. Connect on LinkedIn, where we’re Friends.

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