Tobin's Q No Longer Bullish on U.S. Equities

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Includes: QQQ, SPY
by: The Manual of Ideas

In a report released on June 28, Manual of Ideas editor John Mihaljevic estimates that Tobin's Q, which compares market value to replacement cost, has risen from a March low of 0.33 to 0.72 today. This puts the current ratio roughly in line with the average recorded during the period 1900-2009.

While Tobin's Q sent a strongly bullish signal in early March, today's signal is rather muted. Based on historical experience, Q implies a neutral equity outlook over a 1-3 year time horizon and a modestly bearish outlook over a 5-10 year period.

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Mr. Mihaljevic, who worked with Nobel Laureate James Tobin on developing a new methodology for estimating Q in the mid-1990s, shares the following key findings:

  • We estimate that Tobin’s Q increased from a March low of 0.33 to 0.72 as of June 26, roughly in line with an adjusted average of 0.71 for the period from 1900-2009. Our data shows that while Q declined sharply in 2008, it has increased from 0.55 at yearend 2008 and from 0.61 at the end of 1Q09. The numerator (market value) and denominator (replacement cost) of the Q ratio were up 11% and down 1%, respectively, in the first quarter.
  • Today’s Q ratio sends a neutral near-term and medium-term market signal, and a modestly bearish long-term market signal. Of the five other instances since 1900 when Q increased to 0.72 or below, it was higher one year later in three instances. Four out of five times, it was higher three years after the initial increase. Five years and ten years after the increase, it was higher in only one of five instances and unchanged in another instance.
  • Replacement cost declined 0.7% sequentially in 1Q09, a reversal from a sequential increase of 0.3% in 4Q08, reflecting deflationary forces at play in the U.S. economy, including rising unemployment, home price erosion, and financial deleveraging. We note that replacement cost has not recorded a full-year decline in any year since at least 1900. Further declines in replacement cost would therefore be very significant in a historical context. We will watch the recent deflationary trend closely, but we do not anticipate that replacement cost will in fact decrease for the full year 2009.

About Tobin’s Q

Q, originated by James Tobin, may be conceptualized as a measure of over- or undervaluation of publicly traded assets. If the market value of an asset exceeds the cost of replacing it (Q>1), there is an incentive to recreate the asset and sell it in the market at a premium to cost. As a result, incremental real investment will tend to force high Q ratios back to parity. No straightforward balancing mechanism exists in the case of low Q ratios. This and other peculiarities of Q are discussed in the report referenced above.