Tobin's Q Ratio Sends Modestly Bearish Long-Term Signal

Written by Robert Huebscher of Advisor Perspectives.

Strong market performance during the second quarter has claimed a victim. Tobin’s Q ratio, one of the most reliable barometers of market valuation, is now 0.72 – up from its March low of 0.33 – indicating the market is modestly overvalued for long-term investors.

Over the short- and near-term the Q ratio indicates the market valuations are neutral. For broad-based equity investors, though, the key to long-term performance is the price at which one enters the market. As we noted in our March 31 article, the Q ratio has been exceptionally accurate – more accurate than the P/E ratio – in forecasting investors’ returns.

John Mihaljevic said that, in three of the five other instances since 1900 when Q increased to 0.72 or below, it was higher one year later. Four out of five times, it was higher three years after the initial increase. Looking five and 10 years out, it was higher in only one of five instances and unchanged in another.

The Q ratio gave similarly overvalued signals of 0.89 at the end of 2007 and 0.70 at the end of the third quarter of 2008, but had dropped to 0.55 at the end of 2008 and 0.61 and the end of the first quarter of 2009.

Mihaljevic is a former research assistant of the late economist and Nobel laureate James Tobin, the original developer of the Q ratio. He now publishes the Manual of Ideas, a quarterly newsletter about the Q ratio and its implications for investors.

Mihaljevic provided the following graph Q ratio values for the last century-plus:

^{This chart consists of two data sets: 1900-1944: We use a modified Blanchard, Rhee, Summers series. We adjust the data to reflect the series' upward bias as compared to the Tobin (new) methodology developed by James Tobin and John Mihaljevic. 1945-2009: We use the Tobin (new) series. We believe this combined set of data from 1900-2009 provides the most accurate historical rendering of the Q ratio.}

^{Source: The Federal Reserve; Blanchard, Rhee, and Summers; The Manual of Ideas.}

The Q ratio measures the market value of a company (i.e., its stock price) relative to the replacement cost of its assets. A value greater than one indicates that a company’s assets could be purchased more cheaply than the company itself and, hence, the market is overvaluing the company, while Q ratios less than one indicate market undervaluation.

Over the last quarter, 11% of the change in the Q ratio was attributable to an increase in the numerator (the market value). The denominator (replacement cost) decreased by 1%.

Mihaljevic noted that 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. Replacement cost has not recorded a full-year decline in any year since 1900.

“Further declines in replacement cost would therefore be very significant in a historical context,” Mihaljevic said. “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.”

Disclosure: No positions.

Comments

[logicalthought:]

How do they price the replacement cost of a great brand? Wouldn't the Q ratio grossly understate the replacement cost of a brand-oriented company?

Jul 08 08:12 AM

[Prudent Man...:]

Interesting analysis. If replacement costs have decreased means that the nominal value of dollars have increased which is why business are holding on to it and banks do not want to lend. Therefore, government employees and BHO and Congress should take wage decreases. Won't stand on my head waiting for that.

Markets may move on their own devices but sooner or later reality determines valuations.

The policies followed by our government today are virtually identical to FDR's in 1933 with more government controls, anti-business, higher taxes, ever-changing regulations, etc. and we know where that took us until Hitler invaded Poland.

The last be innovation to find its way on the economic scene was the Web. All that follower from morphing cell phones to e-business, texting, etc. This creation of a new industrial revolution has had world-wide ramifications and, recently, not all favorable to the U.S. economy. What will be the next innovation as the value added of the web revolution decreases?

Only this will allow real growth in the U.S. economy. Until then our economy will continue to stagnate and this will have grave consequences on our ability to service our ever-exploding public debt and our standard of living will decrease. The political ramifications of this scenario are disquieting, especially with the entitlement generation.

Jul 08 10:06 AM

[Prudent Man...:]

Apologize for my typos in the preceding. I take full editorial responsibility for my errors.

Jul 08 10:08 AM

[Larry House:]

Prudent Man...

I used to tell my high school classes when a handout contained a typo, "I would shoot my typist, but that would be suicide." They usually got it--after a few minutes.

Jul 08 01:48 PM

[Random Idea:]

I agree with logicalthought...profits and therefore value has moved away from asset-based returns. In other words, replacement value of assets is of less relevance to a Google than it would be a oil, railroad, or industrial company.

Jul 09 12:26 PM