Saturday, October 10, 2009

Tobin’s Q-Ratio

As the market continues to reward the short-term bulls, let’s step into the mud-laden shoes of the buy-and-hold investor and, alas, into the world of negative returns.

As if this decade weren’t bad enough for investors, Tobin’s Q-Ratio is sending a long-term bearish signal. The Q-Ratio measures the market value of a company relative to the replacement cost of its assets. If the value is greater than one, the market is overvaluing the company; less then one, the market is undervaluing it. The investor, of course, wants the market to overvalue a company whose stock he holds.

According to John Mihaljevic, as of September 21 the market-wide Q-Ratio was 0.86, a level the ratio has reached 11 times since 1900. How much follow-through is there for the Q-Ratio after it reaches this level? On a ten-year time horizon the prospects are bleak. In every measurable instance it was lower 10 years later; the last time was 2002-03, so the jury is still out on that result.

Of course, as with any economic forecasting tool, there are always circumstances under which it won’t work. If, for instance, we have an inflationary environment where replacement costs increase at a faster than normal pace, stock prices could rise. But, then again, we know that high inflation is bad for equity prices.

The source for this information, by the way, is the Advisor Perspectives newsletter of October 6, 2009. In an earlier post I gave a link to sign up for a free subscription.

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