Don’t Fret About Tobin’s Q
Bloomberg has a piece this morning on another valuation indictor, this time it’s Tobin’s Q, showing that the stock market is dramatically overvalued.
If you sold every share of every company in the U.S. and used the money to buy up all the factories, machines and inventory, you’d have some cash left over. That, in a nutshell, is the math behind a bear case on equities that says prices have outrun reality.
The concept is embodied in a measure known as the Q ratio developed by James Tobin, a Nobel Prize-winning economist at Yale University who died in 2002. According to Tobin’s Q, equities in the U.S. are valued about 10 percent above the cost of replacing their underlying assets — higher than any time other than the Internet bubble and the 1929 peak.
I’m usually very skeptical of these market models. For one reason, just because the market is over-valued doesn’t mean that it wont’ become even more richly valued. It’s very difficult to precisely time when the market will pop. The bubble of the 1990s kept inflating for more than three years after Alan Greenspan’s warning. Once again, Janet Yellen has recently warned us about high valuations.
We also have to be careful when we talk about “the market” as if it’s just one giant stock. The great bubble of the 1990s was largely driven by large-cap tech stocks. Many small-cap stocks never surged and hence, never crashed. There are thousands of stocks out there we have just 20 on our Buy List. Small investors can get away with owning as few as eight stocks. I don’t see the need to obsess about “the market.”
I’ll say this again, and it’s an unpopular view, but the stock market rarely reaches a bubble. This shocks people, but I stand by it. By a bubble, I mean when valuations soar dramatically past fundamentals. Just because valuations are elevated, doesn’t mean that’s a bubble—and it certainly doesn’t mean that we’re going to revert to the mean anytime soon. More often, stock prices fall when fundamentals fall. That’s not a bubble. Not every selloff is the ending of a stock bubble. Even in 1929, valuations weren’t that excessive. Only in the last few months did prices get expensive.
These valuation measures imply that there’s a long-term relationship that’s still applicable. Jack Bogle famously said that the four most dangerous words are “it’s different this time.” But the truth is that it’s different this time. It’s different every time. We value equities more than we used to.
Any investors who based their investment decisions on the Q ratio would have missed most of the rally since 2009, according to Jeffrey Yale Rubin, director of research at Birinyi’s firm. The measure rose above its historic mean three months into this bull market and since then, the S&P 500 has climbed 131 percent.
The valuation revolution happened in the 1950s and 60s, and we’ve never gone back. Notice how rarely anyone talks about the stock bubble of the 1950s. Stocks had an amazing run from 1949 to 1956. It’s one of the greatest on record. But it’s not considered a bubble…because it never crashed.
For some reason, it’s considered much more sophisticated to warn that stocks are in a terrible bubble. No one gets credit for telling people that there’s not much to worry about.
Posted by Eddy Elfenbein on May 18th, 2015 at 9:49 am
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