| |
| |
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. The data for making the calculation comes from the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly for data that is already over two months old. I first discussed the Q Ratio in an article in early April based on the March release for data through Q4 2009. The release for Q1 of 2010 is scheduled for June 10th. I'll post an update as soon as possible after I have the Fed numbers.
Here is a chart of the Q Ratio since 1900. The years before 1945 are annual estimates shared with me by John Mihaljevic, who served as Dr. Tobin's research assistant at Yale. The Federal Reserve began issuing annual Flow of Fund releases in 1945 and started quarterly releases in 1952. The chart data from 1945 to the present are my calculations from the government releases. The more jagged appearance of the chart after 1952 is a result of the switch to quarterly data.
Interpreting the Ratio
The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102., Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 35 (Market Value) divided by Line 32 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that "the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same."
The average (arithmetic mean) Q ratio is about 0.70. In the chart below I've adjusted the Q Ratio to an arithmetic mean of 1 (i.e., divided the ratio data points by the average). This gives a more intuitive sense to the numbers. For example, the all-time Q Ratio high at the peak of the Tech Bubble was 2.58 — which suggests that the market price was 158% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.43, which is 57% below replacement cost. That's quite a range.
The More Complicated Calculation of Tobin's Q
John Mihaljevic, who was Dr. Tobin's research assistant at Yale and collaborated with Tobin in revising the ratio formula, uses a more complex formula based on the Flow of Funds data for calculating Q. The formula is explained in detail at Mihaljevic's Manual of Ideas website. The chart below uses the Mihaljevic/Tobin formula for the Q calculation.
I would make two points about the more intricate formula. First it produces results that are remarkably similar to the simple calculation (first chart above. Also, the chart here differs somewhat from the version posted at the Manual of Ideas website (reproduced here), even though my chart uses the Manual of Ideas calculation formula. I've corresponded with John about the differences, and he explained them as an artifact of undocumented revisions to the government's Flow of Funds data. The Manual of Ideas Q Ratio is updated quarterly when the latest Z.1 numbers are released, and no changes are made to the ratio for previous quarters. My charts were built from scratch with the historic Z.1 data with any undocumented revisions included.
Extrapolating Q
Unfortunately, the Q Ratio isn't a very timely metric. The Flow of Funds data is over two months old when it's released, and three months will pass before the next release. To address this problem, I've been collaborating with Jacob Wolinsky to make preliminary estimates for the Q Ratio for use in his monthly valuation update. We've been experimenting with extrapolations for the more recent months based on changes in the market value of the VTI, the Vanguard Total Market ETF, which essentially becomes a surrogate for line 32 in the data. Thus the Q Ratio for December 2009, based on the Z.1 numbers, is 0.98. Extrapolations for January through May are 0.95, 0.98, 1.04, 1.06 and 0.98, respectively. When the new release is published a week from today, Jacob and I will get an idea of how reliable our extrapolations have been and make adjustments going forward, as needed.
The Message of Q
The mean-adjusted charts above indicate that the market remains significantly overvalued by historical standards — by about 39% in the arithmetic-adjusted version and 50% in the geometric-adjusted version. Of course periods of over- and under-valuation can last for many years at a time.
Also, there are some economists who question the validity of the Q Ratio. They protest, among other things, that the ratio doesn't account for intangible assets in the equation, which makes the data for more recent decades questionable. This is a topic I'll explore in more detail after I've posted the new Q Ratio numbers with the release of the Q1 Flow of Funds report on June 10th.
|
|
