TOBIN’S Q SAYS THE MARKET IS STILL CHEAP
This from the Disciplined Approach to Investing Blog:
“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.”
Replacement cost has to be one of the most subjective measures out there. Price to Sales is the best in my opinion as sales are least subjective measure.
From a previous post of yours: “The long-term average (since 1952) for Tobin’s ‘q’ is 0.75.”
So, 0.78 doesn’t exactly look cheap, especially given the Q3 number should be higher.
yeah tradeking I was just looking at the chart and see that in the 82 recession, it got ridiculously low. Who’s to say we won’t end up there again?
Yeah, that huge overshoot to the upside will require an equal overshoot to the downside.
The 70s and early 80s saw low P/E, P/S and Tobin Q ratios because inflation and interest rates were high. The discounted value of the market was therefore low. If interest rates get to double digits again due to high inflation, then the market should collapse in real terms (lower P/E, P/S, Tobin Q) but that doesn’t necessarily mean it will collapse in nominal terms.
The S&P500 went from 90 in January 1970 to 181 to January 1985. However, $90 in 1970 was equivalent to $250 in 1985 (per the BLS CPI). So investors saw the real value of their stock (excluding dividends) decline 27% over those 15 years even though their stock doubled in nominal terms. Even 5 years later in July 1990 investors had only broken even in real terms. The entire real return for 20 years was from dividends alone. No real capital appreciation.
It still appears that deflation is the biggest worry today, but I hope that the Fed isn’t setting us up for another two lost decades were we should be happy just to get a 1% or 2% real return.
The stock market is probably undervalued today if neither deflation nor inflation set in. If prices are stable and interest rates remain historically low for the foreseeable future and companies regain pricing power with a recovery in economic activity. i.e. the Goldilocks scenario.
By the way, S&P500 at 90 in 1970 is equivalent to about 500 in 2009 when converted using the CPI.
Replacement cost is meaningless if existing assets are under-utilized. Right now, US industrial utilization is at 69.6% (August), and is essentially unchanged since March. That should mean that based only on replacement of utilized assets, equities should be selling at a “Q” of about 0.7.
We should take “Q” with a grain of salt however, since many of the “assets” represent outdated inefficient technology, or worn-out physical plant that is over-appraised.
In the real world, equity prices should be based on REPORTED earnings, not estimated earnings, not sales volume, or replacement cost. Knowing the difference is what separates a financier from a speculator.
I stand completely corrected. I didn’t think about that. Great points Rob. Care to recommend some books regarding the history of the stock market (ie a book that presents facts like you just did?) I’d really appreciate it.
Question for you though, do you think that companies will be able to regain their pricing power? I don’t cause of the deleveraging process and saving for retirement that needs to take place…and because of that, companies aren’t gonna invest in capital equipement if they already have such huge capacity overhangs.
you dont understand or misinterpret “q”
q is currently valuing the market at 40% OVERVALUED
look at smithers&co website
YOU should be more responsible!!!!
A graph of Q vs. 10-year future returns yields an R-squared of about .4. Not bad for a very long term forecast. I’d show you the scatterplot, but I don’t know how to insert pdf’s.
Does Tobin know what is the replacement cost of the banks assets?
Does Tobin know the forward looking profits of listed cies?
Peter, you are wrong. Tobins Q says the market is overvalued when it’s over a value of 1. TPC is right. http://en.m.wikipedia.org/wiki/Tobin's_q?wasRedirected=true
Excellent points Rob,thanks.
By the way, I think that the Goldilocks scenario is very unlikely. But I do think that the market has been and will continue to price in a Goldilocks scenario until something happens that makes it clear that Bernanke won’t be able to keep equilibrium between inflation and deflation forever. One or the other will win out. I hope for mild deflation and a stable to strengthening dollar, but fear that the inflationists might just be right.
One of the best recent books I have read on investing in equities is Ken Fisher’s “The Only Three Questions That Count”. In my opinion he is too bullish on equities but if you understand where he is coming from it is a good read. (He thinks most people should be 100% in equities most all of the time). He stresses diversification within equities but not among asset classes which I think is a mistake, but his insights on investing in equities are quite good. The chapter on bear markets is especially good. The book was written before the 2008 crash and this time around he didn’t take his own advice. He didn’t see it coming and his clients are the poorer for it.
I find it strange that so few people saw it coming when it was so obvious the housing market would turn into a disaster. The problem is getting the timing right and anticipating how the government and the Fed will disrupt the markets.
The next crisis which no one is really paying much attention to is the effect of high levels of long term unemployment on the economy, company sales and pricing power. Unemployment is still only 9.8% and U6 at 17% and the average length of unemployment is only about 27 weeks. Both are headed higher. I bet this time next year the effects of high long-term unemployment will be front and center with home foreclosures setting new highs and sales of big ticket items setting new lows.