Monday, September 9, 2013

Is There Such a Thing as "Austrian Investing" ?

There is quite a bit of excitement in some Austrian circles over a new book by Mark Spitznagel, The Dao of Capitol: Austrian Investing in a Distorted World. I read the book over the weekend and found it a major disappointment. At times, I found the book odd, at other times confused, sometimes bizarre, occasionally inconsistent and sometimes just plain wrong. I am convinced I could write an entire book on the problems with The Dao of Capital.

I won't do that, however. Indeed, I won't even review the entire book. I will just point out a half dozen, or so, problems I have with the book. You can take it from there.

The first problem I have is Spitznagel's attempt to wrap everything in terms of Daoist philosophy or Austrian economics, when discussing pretty basic concepts. It makes for all kinds of confusion and stuffing of concepts where they don't belong. For example, in Chapter 1, Spitznagel discusses Mises use of the phrase: "false prices".

Spitznagel writes:
Here was Mises's whole description of the market process, "always disquieted by a striving after a definite state of rest," with each resulting price an error around the final state price; and these errors, what Mises called "false prices," were the local's edge.
By "local's edge," Spitznagel is referring to traders in commodity pits. But, Mises' only uses the term "false prices" once, in his book Human Action (p.335), and he is not discussing traders when he is using the term, but an environment when there are no previous prices. The paragraph from Mises, before the one Spitznagel quotes, reads (my bold):
If the memory of all prices of the past were to fade away, the pricing process would become more troublesome, but not impossible, as far as the mutual exchange ratios between various commodities are concerned.
In no way was Mises referring to traders, whose entire trading life depends upon understanding just passed prices in relation to future prices.  Indeed, in the sentence where Mises uses the term "false prices,"  he states that "false prices" can not survive.

Here's the full sentence Mises wrote that Spitznagel only snips (my bold):
The essential fact is that it is the competition of profit-seeking entrepreneurs that does not tolerate the preservation of false prices of the factors of production.
Spitznagel completely misunderstands what Mises is writing about here. He is writing about price discovery where there are no past prices, not the trader's world of constant price signals. The role of a trader in providing liquidity to markets can make for a long fascinating discussion, but it has nothing to do with "false prices."

The essence of Spitznagel's Chapter 1 is "Cut your losses, let your profits run." This is a long time investment adage, that works in some kinds of trading, but not others. But, it has been around a long time. Here is DFX writing about it:
Cut Your Losses Early, Let Your Profits Run
Countless trading books advise traders to do this. 
Wrapping it in Daoist thinking, or misunderstood Austrian theory, doesn't change it from being an adage that has been around for a very long time. It certainly doesn't call for any particular Austrian insight to understand it. And I emphasize, it is only of limited use, for certain types of trading. It would have no application at all, for example, for someone who has identified a significantly undervalued stock that falls even lower in price short-term.

Let's move on.

An odd part of the book is the very long biographies of Austrian economists. I'm talking real long, pages and pages and pages. For example, there is one section where there is a discussion of why Austria's Prince Rudolf, who was tutored by Carl Menger, committed suicide. We also learn that Menger may not have formally married his common-law wife because she was either Jewish or divorced. Menger was Catholic. We also learn much about Mises, including that his father was a construction engineer for the Austrian railroads. This all may be fascinating stuff to scholars, but what it is doing in the middle of an investment book, I am not sure. This becomes even more curious, when as we shall soon see, information about collecting economic data is scant to non-existent in the book.

Spiznagel at another point highlights only half of Mises theory of the business cycles. He writes:
[I]n general the artificially low interest rates will open up the possibility of shortening the overall  structure of production--the very opposite of the natural response when interest rates fall due to greater savings. Mises called this phenomena capital consumption. In the real world, Mises thought capital consumption occurred as a mistaken drive by the perverse effect of inflation on accounting.[...]As we can see, inflationary credit expansion by the banks can unfortunately lead to a reduction of the overall capital structure.
But this is not what Mises says fully. Mises writes of two possibilities an expanding capital structure or a shrinking structure and admits that in the past it has often resulted in an increase in capital:
It may be admitted that in the past inflation often, but not always, resulted in forced saving and an increase in capital available. However, this does not mean that it must produce the same effects in the future, too.
Mises adds:
At any rate, the final effect of such changes upon saving, capital. and the originary rate of interest depends upon the particular data of each instance.
It should be noted that Murray Rothbard discusses only an expansionary capital structure  in his books America's Great Depression and Man, Economy and State.

In AGD, he writes:
In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption-investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful.
Rothbard pretty much says the same thing in MES, and again does not mention a shrinking capital structure:
 First, the money supply increases through credit expansion; then businesses are tempted to malinvest—over investing in higher-stage and durable production processes. Next, the prices and incomes of original factors increase and consumption increases, and businesses realize that the higher-stage investments have been wasteful and unprofitable.[...]
We have seen in chapter 11 that the major unexplained features of the business cycle are the mass of error and the concentration of error and disturbance in the capital-goods industries. Our theory of the business cycle solves both of these problems. The cluster of error suddenly revealed by entrepreneurs is due to the interventionary distortion of a key market signal—the interest rate. The concentration of disturbance in the capital goods industries is explained by the spur to unprofitable higher order investments in the boom period. And we have just seen that other characteristics of the business cycle are explained by this theory.
But there is one other person that I want to highlight who has written about the expanding higher order capital investments, in contrast to Spitznagel. It is Spitznagel himself, in a 2012 paper, The Austrians and the Swan, he wrote:
 When a central bank lowers interest rates, what essentially happens is a dislocation in the market’s ability to coordinate production. The lower rates make otherwise marginal capital (having marginal return on capital) suddenly profitable, resulting in net capital investment in higher-order capital goods, and persistent market maladjustments[...]Credit expansion raises capital investment in the short run, only to see the broad inevitable collapse of the capital structure. Eventually the economic profit from capital investment and the lengthening of the production structure are disrupted, as the low interest rates that made such otherwise unprofitable, longer term investment attractive disappear.

Spitznagel, in this quite amazing "Austrian" book, also launches into, get this, empirical testing: He writes:
First and foremost, this exercise is about restraint. I focus only on what matters and is worthy of testing, and include here the results of each on my scanty tests[...] I insist on keeping the empirical work short and sweet.

What the hell is he talking about here?  One of the primary tenets of Austrian economics is that empirical testing is an incorrect methodology for the social sciences. If nothing else, this certainly is the tell that this is not a book about Austrian economics or Austrian investing.

But from here things get really bizarro. In the book, Spitznagel named an index after Mises. It's called the MS Index. He does note, however, that the index is very close to another index:
It should be noted that the MS index is similar to the well-known Tobin's Q ratio (and in fact my calculated values of the MS index used in Chapter 9 are essentially the same as [Tobin's] Equity Q ratio)
Note to the slow: Getting the same calculated results is a very close index!!

Bottom Line: The MS index, that is named in honor of Mises, is the Tobin Q ratio, which is exactly what Spitznagel called it in a 2011 paper The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes :
 I have established as the most robust metric with which to recognize aggregate overvaluation in the stock market. This is simply because it removes the need to pinpoint the three value drivers and instead isolates only whether or not implied ROIC = WACC in aggregate (which should hold under fair value), in which case nominal levels of the drivers are irrelevant; they become relevant only in amplifying an already over- or under-valued state.
This ratio is essentially the well known Tobin’s Q ratio of Nobel Laureate James Tobin , which is the ratio of aggregate enterprise value (equity plus debt) to the aggregate corporate assets or invested capital7 (or, with no debt, aggregate equity over assets); more specific to equity investors is the equity Q ratio (or Q ratio, which I am using in this paper), which is total equity over the net worth of the firm (where total assets are netted against total debt, so with no debt the net worth is the invested capital)

This is really nuts. It's as if someone vetted the book before it went to press for Austrian consistency and pointed out that Tobin was a Keynesian interventionist and not an Austrian, and the decision was reached, "Hey, no problem. We will just name this Keyensian formula in honor of Mises."  There is nothing, nothing, Misesian about this formula.

Further, I am still trying to understand how Spitznagel uses this formula on a practical level, which seems to be at the core of his "Austrian" investing. By this I mean, where is he getting current data?

Above, I pointed out that Spitznagel has pages and pages of biographical material on Austrian economists. Yet, when it comes to the source of data for Tobin's Q formula, there is this:
Now for some housekeeping: As discussed in Chapter 7, the MS index is very well represented by what is known as the (Tobin's) Equity Q ratio---total U.S. corporate equity divided by total U.S. corporate net worth, which is readily available online trough numerous sources, and easily computable using Federal Reserve Flow of Funds balance sheet data.
So note well, although he provides details on the suicide of Menger's student Prince Rudolf, and the common law marriage of Menger, in a supposed investment book, he does not provide sources on just where to find the data, other than the Federal Reserve, for the most important formula in the book! But, it gets worse, relative to the reference  to Fed data, he does not provide information on how exactly the data is "easily" computed from the Fed flows data.

But here is the real kicker, it is pretty much impossible to use the Fed data in any manner to forecast the market. Putting  aside for the moment that I don't see the formula as having anything to do with Austrian economics, and that, at best, I see it as a coincident indicator rather than a leading indicator. You can't get current data anyway. As I write this on September 9,  2013 the most recent Flow of Funds data online at the Fed is for the first quarter, that means it ends March 31, 2013. In other words, it is currently more than 5 months old. How the hell are you supposed to forecast the current market with data more than 5 months old?

There's plenty more in this book, plenty,  that I find confused, wrong and bizarre. But, as I say, I don't want to spend the time to write a book rebutting everything.

I happen to think Spitznagel is a very good trader, but he uses long tail trading in a manner that he doesn't discuss in his book at all. There should have been much more about that. I suspect he sticks to Louis Litt's  tactical rule # 7: Never disclose your tactics.

A final note, I think there are ways that Austrian economics can be useful in investing, particularly in understanding how central bank money manipulations distort the economy and how regulations can have an impact on investments, but the details of how that is done is either presented in a confused manner. or not at all, in this book.



  1. Just make sure any book comes after your IP book.

  2. Is there a book that you do recommend? I am still trying to get a solid grasp on (Austrian) investing and my understand up to now seems to suggest that much of the system is illusory, driven by those who wish to keep the illusion going.

    1. As far as Austrian economics, know the business cycle, which Rothbard details in a number of books, America's Great Depression, The Mystery of Banking and in Man, Economy and State.

      After that it is pretty much studying investing, though Austrian insights into how interventions and regulations impact companies can be valuable.

    2. Glad to know Ive done all the right things up to now. Thanks!

  3. OK you clearly decided against reading the entire book. Spitznagel is using false prices correctly, as the very prices which entrepreneurs (which he clearly connects to pit traders) correct in their profitable actions. And he very clearly explains how the q ratio and his empiricism (which is but a footnote in his book) is entirely Austrian. All of your criticisms are already addressed by Spitznagel. You are just pointing out what he pointed out. And, as for bios, this is likely the most comprehensive as well as practical Austrian book there is. You should be glad it exists, as when was the last time an Austrian book did so well on Amazon!?

    1. How is Wenzel not reading the book, when he quotes from it? He is correct when he states that false prices is used in a different manner by Mises than Spitznagel. He has the quotes. Mises wasn't talking about pit traders.

      Further, Spitznagel may think he has proved that "the q ratio and his empiricism is entirely Austrian," but that flys in the face of everything I know about Austrianism. It is absolutely absurd that Mises would adopt Tobin's Q ratio and empiricism for anything.

  4. Btw, Spitznagel furthermore clearly states in the book that his explanation of how artificially low rates is actually contrary to aspects of Austrian theory. Again, you're just repeating what he said! His is a fascinating extension of the theory when an entire yield curve is introduced and people are hyperbolic discounters. This is great stuff. And he basically fills in the gaps of why capital investment doesn't expand in practice in response to artif lower rates. You're review is unfair and leaves out all of his excellent explanations.

    1. But, but, in his 2012 paper, as Wenzel points out, Spitznagel says it expands!

      How do you explain the real estate boom and stock market boom before the financial crash of 2008, if capital investment didn't expand?

  5. MS index = Misesian Stationarity index. The q ratio (or MS index) entirely reveals when Mises idea of stationarity (complex as it is) is implied in the market, and from there Spitznagel's analysis of stock market crashes and valuation is downright fascinating and even empowering. Nothing to do with Austrians and Mises? Please! Read the book again, and again, and...

    1. Hey, anonymous I can think of a dozen reasons there is a difference between market value and replacement value. For starters, maybe replacement value ( a calculated value) has not caught up to market prices when, duh, market value has. It has nothing to do with Mises stationarity---another term that Mises never used, btw.

  6. Clearly Spitznagel was quoting the austrian line in his paper, before refining it as he does in his book. Capital investment boom in 08? Look at the q ratio then and say that. It was a speculative boom for existing equity, the numerator, (Spitznagel's whole point!) relative to new capital, the denominator. Not a new investment boom at all! Look at the data.
    Banacek: That doesn't make sense. Spitznagel applies austrian theory versus your nontheoretical suuposition and you're upset?

    I'm sorry, I just think you guys are throwing out obvious stuff that Spitznagel himself even specifically calls the readers attention to and addresses, and you need to go back and read his book more thoroughly.

    1. 1."Refining it"? Taking the opposite position before taking his current position. Yes, that would be a revision. Wooha!

      2.How exactly is the Tobin theory Misesian, it's just a complex version of price to book value? Nothing Austrian about it.

  7. It seems like a refinement to me. Both involve destructive malinvestment (one in new capital and one in existing) and both still involve an illusion of real economic growth, as Spitznagel points out. And, of primary importance to Spitznagel, of course, both lead inexorably to a crash. I know it's not obvious, but it is an extension that leads to the same general business cycle.

    How is MS index Misesian? It indicates departures from an implied stationary economy, and that's really important to ABCT as Spitznagel clearly explains. Remember that whole inconvenient Austrian concept of the underlying theory mattering the most? That's why Spitznagel's development of this not "just a complex price to book value "

  8. The best I've read is Victor Sperandeo's "Trader Vic - Methods of a Wall Street Master" and "Trader Vic II - Principles of Professional Speculation." His analysis of economics is based on Mises. Not perfect but much better than Spitznagel (who I think is hiding his actual strategies as Bob suggests).