What Does Tobin's Q Really Mean?

As the market has climbed higher and higher, many bears have pointed to the elevated “Q ratio” as a reason for concern. But just what does the Q’s high level mean for investors today?

A recent Bloomberg piece examined the issue and found some diverse opinions on what the Q ratio, developed by Nobel laureate James Tobin, means today. The ratio compares the total value of the stock market to the cost of replacing the underlying assets of all companies in the market. Today, it’s higher than any time other than the Internet bubble and the 1929 peak, Bloomberg says.

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Andrew Smithers, former head of SG Warburg’s investment arm, told Bloomberg that the high Q ratio is a sign of the havoc that quantitative easing has played. “QE is a very dangerous policy, in my view, because it has pushed asset prices up and high asset prices, we know from history, are very dangerous,” Smithers said. “It is very strongly indicated by reliable measures that we’re looking at a stock market which is something like 80 percent over-priced.” Smithers says the high Q is the result of companies choosing share buybacks over capital spending and near-zero interest rates pushing investors into riskier assets like stocks.

Others question the metric’s value, however. Laszlo Birinyi of Birinyi Associates notes that using the Q as a timing tool would have meant you missed just about all of the current bull market. “The issue we have with Tobin Q is that it does a very poor job at timing the market,” Jeffrey Yale Rubin, director of research at Birinyi’s firm, said. “The followers of Tobin Q never told us to buy in 2009, yet now we are warned that we should sell. Our response is sell what? We were never told to buy.”

George Pearkes of Bespoke Investment Group notes, meanwhile, that the shifting of the economy from capital-intensive firms like railroads and steelmakers years ago to technology and service firms today makes the Q less relevant. “Does that necessarily mean that the Q ratio should be as high as it is right now? I don’t know,” Pearkes said. “With those sorts of long-term indicators, they can sometimes mean that the market is overvalued. But the reversion to the mean on them is usually going to take a lot longer than most people’s time frame.”