TAILIEUCHUNG - The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes

Our econometric investigation is based on two different complementary (weekly and monthly) datasets, respectively from 7 June 2005 to 21 October 2008, and from January 1996 to December 2007. There are two main reasons for this. Firstly, we think that weekly data may adequately capture the interaction of oil and stock prices in the region better than any other data frequency. However, our weekly data set, which deals with all the six GCC countries, only includes less than four years of data, which can be considered as too short to test for causality | Universa Working White Paper June 13 2011 The Dao of Corporate Finance Q Ratios and Stock Market Crashes Mark Spitznagel Chief Investment Officer Takeaways s This white paper provides clear and rigorous evidence of a direct relationship between overvaluation and subsequent extreme losses in the aggregate stock market. s Of equal importance is the use of the Q ratio as the most robust aggregate overvaluation metric which isolates the key drivers of valuation. s At current valuations Q and if this 110-year relationship continues there is an expected median drawdown of 20 and a 20 chance of a larger than 40 correction in the S P500 within the next few years these probabilities continually reset as valuations remain elevated making an eventual deep drawdown from current levels highly likely. Not a Pretty Picture Historically the higher the Q ratio the fatter the subsequent left tail in the S P500 with 99 confidence . Universa Investments . all rights reserved 1 Methodology I begin with the deductive exploring the corporate finance-based validity and robustness of the Q ratio as the appropriate measure of aggregate equity market valuation and move to the inductive with an investigation of the empirical relationship between the Q ratio and crashes utilizing non-parametric measurement of tails through straightforward quantile estimation and significance tests thereof. I. The Dao of Corporate Finance I start with first principles a review of basic valuation which will require only middle school maths . First the firmfoundation principle from the 1938 book The Theory of Investment Value by Williams 1 which identified a stock s valuation as the discounted value of its stream of future dividends. This is the later formalized Gordon-Shapiro dividend discount model or constant growth model from 1956 2 Dividend l Value ------------ y-g where Dividend 1 is the next dividend y is the discount rate and g is the constant growth rate of dividends. Next it is of course more .

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