Market Valuation: Minding Your P/Es and Qs

Includes: DIA, QQQ, SPY
by: Doug Short

The ten-year inflation-adjusted ratio of price to earnings has been a favorite long-term indicator of market valuation that I regularly update on my website.

Another ratio, less familiar and more tedious to calculate, was developed by economist and Nobel laureate James Tobin. Tobin's Q Ratio is based on the assumption that the combined market value of all the companies on the stock market should be about equal to their replacement costs.

John Mihaljevic, who served as Professor Tobin's research assistant from 1996-98, assisted Tobin in developing a new Q estimation methodology and in periodically updating data related to the Q ratio. John continues to maintain the Q Ratio in an online subscription service at The Manual of Ideas. In addition to monitoring the Q Ratio for the aggregate US market, the service also tracks Q for the 1,000 largest US-listed public companies ranked by market value.

The chart below provides an opportunity to compare the annual Q Ratio with the inflation-adjusted S&P Composite:

Admittedly, the comparison is a bit of apples-to-oranges in that the base for Q Ratio is much broader than the S&P 500, since it is calculated from the Federal Reserve Board's Z.1 statistical release, Flow of Funds Accounts of the United States. The calculation formula is fairly simple (if rather cumbersome to compute), and it is fully documented at the Ideas website. If the market's value consisted solely of its documented assets, Tobin's Q would be 1.0. Such has not been the case. So I've taken the liberty of adding both the average for Q over this 110-year timeframe (0.71) and the geometric mean (0.65), which favors the central tendency of the set of numbers.

The chart below is my latest update of the S&P Composite and the P/E10. A comparison with the chart above shows a remarkable similarity between these two radically different measures of market valuation.

I receive numerous emails from readers who question the validity of the P/E10 valuation over such a long timeframe. Their objections usually have an underlying assumption that the world has undergone a dramatic change since those bygone decades. They note that today's market has the benefit of new technological efficiencies, it's composed of different stocks, and intangible assets are inadequately accounted for because we've transitioned from an industrial nation to a nation of services in the Information Age. Readers of this opinion will be inclined to discount the 44.2 P/E10 and 1.88 Q Ratio near the top of the Tech Bubble.

Perhaps they're right and we'll never again see a single-digit P/E10. Perhaps the Q Ratio of 0.55 in 2009 is the contemporary equivalent of 0.29 in previous decades. On the other hand, those huge peaks in the two ratios may have been the result of a long-term but inevitably reversible demographic pattern — a generation of Boomers approaching their highest income years in an era of unprecedented consumption.