Markets move in two directions, up and down. Ok, sometimes sidewise for a while. Five years of a remarkably steady ‘upward’ movement in stock prices can give a false sense of security to an otherwise prudent investor who may get caught off guard by a swift reversal in equities. In looking for signs to help make your investment decisions, let’s look at Tobin’s Q, which has predicted many of the major stock market declines in the past century.
James Tobin, Nobel laureate from Yale University, developed the Q ratio, also known as “q”, in the 1960s as a means to assess whether the stock market is over- or under- valued. When the Q ratio is high relative to its historical average, stocks are overvalued. The Q Ratio chart created by Doug Short shows the current q at 1.12. This is above four of the past five highs that were followed by significant pullbacks in stocks. The 5th and highest Q ratio was during the dot com bubble when q reached 1.64 in 2000. We know what followed.
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The current Q ratio of 1.12 implies equities are 65% overvalued. The valuation calculation measures the difference between the current Q and its historical average. (1.12-.68) ÷ 0.68. Andrew Smithers & Stephen Wright, authors of a book devoted to understanding the Q ratio, “Valuing Wall Street”, show us that q has the quality of “mean reversion”. When the stock market is incorrectly valued it will fall or rise to return to its average. Therefore, when the market is overvalued there is a high risk that it will perform poorly in the future.
To understand the relationship between the Q Ratio and stock prices we can look at how q is calculated.
Tobin’s Q = Market Value of Stocks/Replacement Cost of all of the Companies
The ratio gets larger when stock prices increase faster than the increase in replacement costs.
It is a rather simple calculation because the government does all the heavy lifting by providing the data in its publication Federal Reserve Z.1 Release at http://www.federalreserve.gov/releases/z1/ table b.102 lines 33 and 36.
Markets can be over- or under-valued for long periods of time. This metric is best for long-term investors. It isn’t a good indicator of shorter term market moves.
A high ratio is an indicator that future returns will be low. The ratio can be a valuable tool in helping you preserve wealth. It suggests that buying stocks today may not be in your best interest. It may be interpreted as a sign to rebalance your portfolio to your long-term allocation or build a cash reserve that will be available for buying stocks when prices decline. Cash is king when stocks are cheap.
This article does not offer investment advice. It is provided solely for the purpose of information and knowledge.