In the latest issue of Equities and Tobin’s Q, John Mihaljevic (CFA and managing editor of The Manual of Ideas blog) explains that the “Q” ratio made famous by Nobel Laureate James Tobin indicates that stocks are undervalued right now — but says that there could still be further declines before a turnaround. (A special thanks to the Manual of Ideas for highlighting this data.)
The Q Ratio divides the total market value of stocks by their total asset value (or replacement cost). From 1900-2008, Mihaljevic says, the adjusted average Q Ratio was 0.76 for the market. As of March 15, he estimated it at 0.43, down from 0.55 at the end of 2008, and from 0.89 at the end of 2007.
“Absent major deflationary pressure on replacement cost, we expect Q to return to parity through an increase in the numerator, i.e., a rise in the market value of equities and other assets,” writes Mihaljevic, who once worked as a research assistant for Tobin. “How long this process may take is obviously a crucial question but also one that cannot be answered reliably.”
For investors, the current Q Ratio seems to present a similar picture to that of the 10-year P/E ratio: It indicates that stocks are cheap, but not as cheap as they have been at other points in history. “Despite the low value of today’s Q ratio, it sends only a modestly bullish signal for investors,” Mihaljevic writes, noting that there have been six other times since 1900 when the Q hit 0.43 or lower. In half of those instances, the Q Ratio was higher a year later; in four of the six instances, it was higher three years later; and ten years after, it was higher in five of the six instances. “We cannot overemphasize the possibility of Q reaching extreme levels,” he says, noting that the Q Ratio reached a low of 0.29 in both 1948 and 1974. It was also 0.33 or lower from 1918-1921, and in 1932 and 1949.
Mihaljevic says those who say the current Q Ratio is extremely bullish or extremely bearish are ignoring some important points. The former are ignoring the direction of the Q change. If the Q is at 0.43 and rising, that’s “highly bullish”, he says; if it is 0.43 and falling, that is only “modestly bullish”.
Those who say the current Q Ratio is an extremely bearish sign, meanwhile, are missing three key points, Mihaljevic says:
- “Attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns.”
- “The relationship between Q and stock prices is not quite linear. We estimate that a 50% drop in Q from current levels would be accompanied by a one-third drop in stock market indices.”
- “Replacement cost, the denominator of the Q ratio, has increased each year since 1946.”