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Tobin's Q ratio

The Q ratio, or Tobin's Q, can be a reliable measure of stockmarket value. Introduced as a concept by Nobel Laureate Professor James Tobin in 1969, it compares the total market value of the companies whose shares make up an index with their net worth as measured by their replacement cost (what it would cost to recreate their businesses

Historically, the Q ratio has always reverted to a long-term average of about 0.64 - usually via increases or decreases in stock prices, as these move far more rapidly than net worth. So comparing the current value with this figure allows investors to gauge the current degree of over- or under-valuation of a market.

Q can be calculated for many markets such as the S&P 500 or the FTSE, but data constraints render it much less useful for other markets or individual shares. Critics of the Q ratio claim that its emphasis on tangible assets - such as plants and inventory - unfairly neglects important intangibles, including brands and intellectual property.

There are many different ways to value the stock market. We are waiting for the Coppock Guide to give us a signal by month‟s end (just a few more days left). The usually reliable price earnings ratio has gone haywire, but the dividend yield ratio is still valid.

But what if I told you there is an even better way to sum up the valuation of the stock market in just one number? A method that is both rational and comes with an astonishing track record, having identified every single generational buy opportunity?

Tobin‟s Q was created by the late James Tobin, a pre-eminent economist and professor at Yale. His work garnered him a Nobel prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” But he‟s probably best known for his work on the stock market. Put simply, Tobin‟s Q is a ratio of the current value of the market divided by the replacement value of those same assets.

Think of a factory. It has a market price at which it would be bought and sold. And it also has a replacement cost - what one would have to spend to rebuild it from scratch. The ratio of the

two is Tobin‟s Q. Obviously, that would imply that when the ratio is greater than 1 the

market is overpriced because one could theoretically „rebuild‟ it for a cheaper price than it would take to purchase it. The Q ratio for US equities has fluctuated between 0.3 and 3 in the past 130 years.

It has signaled all the great bear market lows: 1982, 1974, 1949, 1932, 1921. Tobin‟s Q

moves at such a glacial pace that other indicators - even the Coppock Curve - seem twitchy by comparison. But when it does approach an extreme, it pays to give it the respect it deserves.

The best book on Tobin‟s Q is Valuing Wall Street by Andrew Smithers (of Smithers & Co.). It came out at the same time as Shiller‟s more famous Irrational Exuberance.

Both books had the same message and both were published at the exact peak of the 2000

bubble, but Shiller‟s work got more attention because it was written to be more accessible to

the general public while Smithers is more targeted to educated traders and investors. Although both books are good Shiller‟s book stole much of Smithers‟ thunder. You can pick up a copy from Amazon for less than $4 - which is a steal really.

As you might imagine, calculating the replacement value of such a diverse set of ever changing assets is mind bogglingly complex. Thankfully, the Federal Reserve does the heavy lifting. They provide the data in the Flow of Funds Report (pdf document). Look for the numerator on B.102 line 35: Market Value of Equities Outstanding (on page 103) and the denominator: Net Worth on line 32 (same page).

So the ratio resolves to:

9554.1 ÷ 15389.8 = 0.6208

Due to the nature of the data, it is only available quarterly with a lag of a few months. The latest report was released March 12th, 2009 which means the above number is for the fourth quarter of 2008. We should be getting the release of data for the first quarter of 2009 soon. But some analysts also guesstimate the number ahead of time. John Mihaljevic, the former research assistant to Tobin says the current value of Q is around 0.43 - which would be extremely close to the historic low of ~0.30. Following the previous link, you can not only get further details but purchase his complete report.

Obviously the market could fall more and take the Q ratio down with it. But this is further evidence that we are much, much closer to a generational buy point here rather than somewhere along the line of a continuing downtrend. Similar to the Coppock Curve, the Q ratio is not only setting up for a bullish signal but one of epic proportions.

he June 2011 Federal Reserve Flow of Funds report is out. Before I get to the calculation of Tobin‟s Q I‟ll take a brief detour to explain what Tobin‟s Q is and why it is of use for


What is Q?

Q = Stock Price / Corporate Net Worth per Share

Economic Nobel laureate James Tobin wrote about the Q ratio back in the 1960s and now Andrew Smithers of Smithers & Co., Ltd., continues on the tradition with his research firm. In essence it is a simple way to measure whether the stock market is under or over-valued based on the replacement value of the entire stock market. Market valuation is determined from the relationship of the current value of Q to its measurement of fair value.

Why use Q?

The main reason to use any metric of value is whether or not it mean reverts; the Q ratio does mean revert to its measurement of fair value. The Q ratio is a statistical measurement of the

market‟s value and this usually means fair value should be 1 however, with the Q ratio, Andrew Smithers and Stephen Wright have found that with Q fair value is equal to 0.65. Andrew Smithers and Stephen Wright, in their book Valuing Wall Street : Protecting Wealth in Turbulent Markets, discuss several reasons why fair value for Q is 0.65 instead of 1. The primary reason being that capital stock is routinely overstated leading to a larger denominator in the Q equation.

Another reason to use any measurement of fair value is the metric‟s hindsight value or its historical ability to predict when the market is under or over-valued. Again, Smithers and Wright show that amongst all market value measurements tested, the Q ratio has shown the greatest hindsight value (i.e. Over time the Q ratio has reliably shown when the stock market is under or over-valued).

Drawbacks to using Q

Q is not a timing measurement. It is a tool to measure risk in the overall market. The higher the premium to fair value the more risk there is in holding common stocks, while the lower the premium (or greater discount) to fair value the less risk exists in holding stocks. The overall market can stay irrational much longer than anyone thinks possible and Q can continue to climb higher while the market continues to climb. The late 1990s tech bubble is a prime example. The Q ratio signaled an over-valued and very risky market years ahead of

the bubble’s top.

Q is not a money making tool. Investors looking at Q as a way to generate alpha will surely be disappointed. Q is a tool to help investors protect capital.

The measurement itself is not timely. As I discuss below, the data needed to calculate Q is from the Federal Reserve‟s Flow of Funds report. This report comes out every quarter and by the time it is published the data will already be a couple of months old.

How to measure Q

Q can be calculated using the latest Flow of Funds report from the Federal Reserve. The two line items needed can be found in table B.102. The numerator is line 35 “Market Value of Equities Outstanding (includes corporate farm equities)”. The denominator is line 32 “Net Worth (Market Value)”.

Current Q

Based on the June 2011 Flow of Funds report Tobin‟s Q currently resides at 1.03.

How to Trade

According to one of the trading strategies outlined by Smithers and Wright in their book, investors should get out of stocks when Q rises 50% above fair value. Currently Q is 58.5% above fair value.

Remember, Tobin‟s Q is not a timing mechanism; it is a measurement of risk. The stock market can continue higher regardless of what any metric of valuation is showing. It is a tool to help shape an overall investment thesis and to separate short-term concerns and long-term concerns.