Tobin's 'Q' Shows Market Is Still Cheap

Argus Research performed a back-of-the-envelope value of Tobin’s ‘q’ – which is a measure of market valuation. This is based on the Federal Reserve's recently released quarterly Flow of Funds data for the second quarter of 2009.

Investors will recall that 'q' is defined as the ratio of the market value of a firm to the replacement cost of its assets; in this case we are estimating those figures for the entire industry. According to Nobel Laureate James Tobin, the ratio of total stock market value to the stock market’s net worth (corporate net worth) is a reliable indicator of market valuation. When the stock market trades at a ‘discount’ to the replacement cost of its assets, the market is inexpensive, or cheaper to buy than build. This discount possesses 'q' ratios that are less than 1.0. Conversely, when 'q' exceeds 1.0, the market trades at a premium to its replacement cost. The run-up from 1996-2000 had 'q' approaching the unthinkable value of 2.0. The most recent (QII 2009) level of 0.78 is notably higher than the 0.65 posting in the first quarter, which was the lowest since QIV 1990.

Click to enlarge:

Source: Charles Schwab & Argus Research

Comments

[chap08:]

Rather than taking a value of 1.0 as the "right" value, it makes more sense to measure current q against the historical average. On that basis, the market is slightly overvalued.

Oct 01 06:15 AM

[jeremiah74:]

"nothing is cheap when it gets cheaper" - unknown ship merchant from 1500 B.C.

Oct 01 06:20 AM

[bartpr:]

the q ratio is in a downtrend for the last 10 years. it could only reach 1 in the move up in the last 10 yrs. the next move never reach it. odds are for another stab at a down coming.

Oct 01 08:05 AM

[johnm:]

The q ratio at the end of the four "great recessions" of the past was around 0.3 in 1921, 1932, 1949 and 1982. I dont think we are at the bottom of this great cycle (the down leg that started in 2000).

Oct 01 09:12 AM

[Kalani Martin:]

One thing the author has not mentioned is that Tobin's research shows that once the ratio hits a peak in a bull market (like it did in 2000) and then breaks down below 1.00 in a bear market, it has always gone down to .03 before sustaining a recovery and changing back to a legitimate bull market again. We never got anywhere near .03 in March, which reinforces that this is just a bear market rally. It serves no purpose to only include bits and pieces of data to support an opinion and exclude arguably the most important piece of data.

Oct 01 09:19 AM

[Baboon:]

In order to assess better the practical significance of q ratio ( buy when it's historically low and sell when it's historically high) one needs to see the above chart overlaid with SP500 index.

Oct 01 09:21 AM

[grey road:]

the author is grasping at straws here, and is what i call a polyanna, no one is buying this stuff.

Oct 01 09:25 AM

[thiazole:]

I think the short and mid term trends here are more telling. The Q ratio looks to form trends that in the short/mid term are very obvious. For the short term, we are rising from a low point anomoly and at some point it will be back in line with where it was before the fall - the mid-term it is showing a coninued deflation from the 2000 bubble. Long term is more complicated, but it is probably safe to say that it rises during secular bull markets until it hits some ridiculous high, then gradually deflates through the secular bear market (which in real market terms, just looks like a flat market with recession crashes).

Oct 01 12:27 PM

[thiazole:]

It has also been pointed out before that the more service based economy will likely bottom out at a higher Q number than before (since the service based industry needs fewer assets).

Oct 01 12:31 PM

[TinyTim:]

Isn't this just a rehash of market value to book value?
The difference between book and replacement value is what, depreciation?

Oct 01 04:34 PM

[David I. Te...:]

I had a reader to my blog provide a scatter chart of Tobin's q and the S&P 500 Index. The chart can be viewed at the below link:

Tobin's q and The S&P 500 Scatter Chart


On Oct 01 09:21 AM Baboon wrote:

> In order to assess better the practical significance of q ratio (
> buy when it's historically low and sell when it's historically high)
> one needs to see the above chart overlaid with SP500 index.

Oct 01 07:28 PM

[David I. Te...:]

Try that link again:

disciplinedinvesting.b...


On Oct 01 07:28 PM David I. Templeton wrote:

> I had a reader to my blog provide a scatter chart of Tobin's q and
> the S&P 500 Index. The chart can be viewed at the below link:
>
>
> Tobin's q and The S&P 500 Scatter Chart

Oct 01 07:29 PM

[untrusting ...:]

Very good point and useful information. Thanks for posting it. One would think that an author would at least attempt to point out important relevant information such as your point. To not do so shows an clear bias.

When one combines the "real facts or history" of the Torbin Q along with traditional market metrics such as PE10 ratios, valuation, etc. it is pretty clear to any objective person that the titles statement "market is still cheap" is total nonsense.


On Oct 01 09:19 AM Kalani Martin wrote:

> One thing the author has not mentioned is that Tobin's research shows
> that once the ratio hits a peak in a bull market (like it did in
> 2000) and then breaks down below 1.00 in a bear market, it has always
> gone down to .03 before sustaining a recovery and changing back to
> a legitimate bull market again. We never got anywhere near .03 in
> March, which reinforces that this is just a bear market rally. It
> serves no purpose to only include bits and pieces of data to support
> an opinion and exclude arguably the most important piece of data.

Oct 01 10:19 PM

[louca:]

It seems to me that we are in a big bear market rally. And we must imagine that probably now (November 11) Q Ratio must be over 0.80, close to 0.85.
I believe that such a relative high valuation, comparable to the weak economy, the weak recovery and high unemployment, lead us to the conclusion that a downward move of the markets is very possible, very soon (even a short crash). The question is "What now to invest? In stocks of companies? In bonds? In Gold? In Silver? Commodities? What?

Nov 11 12:45 PM