The Ideas Report For Serious Investors

In the just-released quarterly issue of Equities and Tobin’s Q, John Mihaljevic, CFA, managing editor of The Manual of Ideas and former research assistant to Economics Nobel laureate James Tobin puts the so-called Q ratio in historical context and draws timely conclusions for equity investors:

• We estimate Tobin’s Q at 0.43, well below parity and well below an adjusted average of 0.76 for the period 1900-2008. Our data shows that Q declined sharply in 2008 and again YTD, down from 0.89 at yearend 2007 to 0.55 at yearend 2008 and to 0.43 as of March 15, 2009. The numerator (market value) and denominator (replacement cost) of the Q ratio were down 49% and up 5%, respectively, from yearend 2007 through March 15, 2009.

• No evidence of deflation can be observed in replacement cost, with the denominator of the Q ratio rising 5% in 2008, in line with the increase recorded in 2007. Replacement cost increased 0.3% sequentially in 4Q08, reflecting a slower pace than for the full year but notably no decrease. 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. How long this process may take is obviously a crucial question but also one that cannot be answered reliably.

• Despite the low value of today’s Q ratio, it sends only a modestly bullish signal for investors. Of the six other instances since 1900 when Q fell to 0.43 or below, it was higher one year later in three instances. Four out of six times, it was higher three years after the drop. Ten years after the drop, it was higher in all but one instance.

• We cannot overemphasize the possibility of Q reaching extreme levels. The ratio hit a low of 0.29 twice over the course of the past century—in 1948 and 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949.

• Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.43 is highly bullish if Q is on the upswing, but when the ratio is on the downswing, a value of 0.43 is only modestly bullish.

• Those who argue that today’s Q sends an extremely bearish signal appear to be making three cognitive errors: (1) Undue focus on historical lows. While the low of 0.29 is materially below today’s Q, attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns. (2) Ignorance of the fact that 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. (3) Ignorance of the fact that replacement cost, the denominator of the Q ratio, has increased each year since 1946.
  

For information on purchasing the full report, visit The Manual of Ideas.