Risk Management for Investors: Be on High Alert

I’ve recently written about the market residing in heady territory due to rich valuations and overly optimistic sentiment despite a significant drop in forward earnings estimates. Another valuation metric is sounding warning bells that the market is not only overvalued, but is trading at a level rarely seen, even in bubbles. That metric is the Tobin’s Q.

Tobin’s Q was developed by Yale University economist, James Tobin. The Q ratio is found by taking the market value of assets and dividing them by the replacement value of those assets. The gist is that assets will be purchased in the marketplace as long as it’s cheaper than developing those assets from scratch.

And that makes perfect sense.

Tobin’s Q can fluctuate wildly from being seriously undervalued all the way to nosebleed overvaluations. The current ratio of 1.09 is not only overvalued, but the second highest in at least 62 years with the exception of the run-up in the late 1990s.

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If we look back historically, we see plenty of opportunities to aggressively add to equities. Replacement value was incredibly cheap in the early 1950s before a huge run in equities that took the market to new highs.

Then, after a nasty bear market in the early to mid-1970s, the Q ratio reached fire sale levels for a few years. While it took a while, it set up the massive secular bull market that started in 1982.

Bubbles that were popped preceded the substantial market gains. But, those bubble periods didn’t experience the levels we see today. Is the current valuation a call for a run for the exits?

Maybe not.

After all, Tobin’s Q reached stratospheric highs in 2000 as the Internet bubble peaked.

However, it is a call to manage risk. In my opinion, investors are pretty terrible at managing risk. Why throw money at the market now with reckless abandon when many indicators such as sentiment, earnings estimates, valuations on earnings and revenues, as well as the replacement value of assets is telling you that future returns are likely to be very low until we clear out some of the speculative excess that exists in the market?

Everyone needs better insight and as such, we need to really look at all of these indicators… just as Ben Benoy does for our Dent Research team. He analyzes sentiment in a very different way and you may just want to take a look at it in a series of free videos currently being offered detailing a peek under the hood. It’ll give you a new perspective on an old concept — making money. You can get more information here.

That said… now is the time to be on high alert. Tighten stops. Allocate new capital cautiously. And, prepare for the better opportunities that lie ahead when everyone else finally runs for the exits all at once.

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Categories: Investing

About Author

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.