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Tobin’s Q Ratio Valuation Gives Bullish Market Signal at Trader’s Narrative

james tobinThere are many different ways to value the stock market. We are waiting for the Coppock Guide to give us a signal by month’s end (just a few more days left). The usually reliable price earnings ratio has gone haywire, but the dividend yield ratio is still valid.

But what if I told you there is an even better way to sum up the valuation of the stock market in just one number? A method that is both rational and comes with an astonishing track record, having identified every single generational buy opportunity?

Tobin’s Q was created by the late James Tobin, a pre-eminent economist and professor at Yale. His work garnered him a Nobel prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” But he’s probably best known for his work on the stock market. Put simply, Tobin’s Q is a ratio of the current value of the market divided by the replacement value of those same assets.

Think of a factory. It has a market price at which it would be bought and sold. And it also has a replacement cost - what one would have to spend to rebuild it from scratch. The ratio of the two is Tobin’s Q. Obviously, that would imply that when the ratio is greater than 1 the market is overpriced because one could theoretically ‘rebuild’ it for a cheaper price than it would take to purchase it. The Q ratio for US equities has fluctuated between 0.3 and 3 in the past 130 years.

It has signaled all the great bear market lows: 1982, 1974, 1949, 1932, 1921. Tobin’s Q moves at such a glacial pace that other indicators - even the Coppock Curve - seem twitchy by comparison. But when it does approach an extreme, it pays to give it the respect it deserves.

Valuing Wall Street by Andrew SmithersThe best book on Tobin’s Q is Valuing Wall Street by Andrew Smithers (of Smithers & Co.). It came out at the same time as Shiller’s more famous Irrational Exuberance.

Both books had the same message and both were published at the exact peak of the 2000 bubble, but Shiller’s work got more attention because it was written to be more accessible to the general public while Smithers is more targeted to educated traders and investors. Although both books are good Shiller’s book stole much of Smithers’ thunder. You can pick up a copy from Amazon for less than $4 - which is a steal really.

As you might imagine, calculating the replacement value of such a diverse set of ever changing assets is mind bogglingly complex. Thankfully, the Federal Reserve does the heavy lifting. They provide the data in the Flow of Funds Report (pdf document). Look for the numerator on B.102 line 35: Market Value of Equities Outstanding (on page 103) and the denominator: Net Worth on line 32 (same page).

So the ratio resolves to:

9554.1 ÷ 15389.8 = 0.6208

Due to the nature of the data, it is only available quarterly with a lag of a few months. The latest report was released March 12th, 2009 which means the above number is for the fourth quarter of 2008. We should be getting the release of data for the first quarter of 2009 soon. But some analysts also guesstimate the number ahead of time. John Mihaljevic, the former research assistant to Tobin says the current value of Q is around 0.43 - which would be extremely close to the historic low of ~0.30. Following the previous link, you can not only get further details but purchase his complete report.

Obviously the market could fall more and take the Q ratio down with it. But this is further evidence that we are much, much closer to a generational buy point here rather than somewhere along the line of a continuing downtrend. Similar to the Coppock Curve, the Q ratio is not only setting up for a bullish signal but one of epic proportions.

Here is a chart of the Q ratio (from 1952 onwards when Federal Reserve data is available):

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18 Responses to “Tobin’s Q Ratio Valuation Gives Bullish Market Signal”  


    Looks to me like John Mihaljevic & Smithers are using differnt methods for the charts.

    I would consider this a signal to find out why, rather than to buy.

    Also, I saw a Smithers commentary recently [sorry - no link] & he was not too optimistic.

  2. 2 Babak

    Paul, the Smithers chart (see above) is comparing Q to its own average. So it is a ratio of a ratio - in other words, it shows a relative Q. That explains the difference. As for not being too optimistic, Mihaljevic isn’t that bullish either, to be honest. But considering everything else we’ve seen and especially if this estimate comes in line (or lower) then I think we’ve got enough reason to be optimistic.

  3. 3 Justin

    When you mention that the calculation is complex, complex is right and unattainable without inputting cost to build overseas. Or am I missing something? It is a brave new world.

  4. 4 badcompany

    Shake hands! Babak. I just borrowed this book from library yesterday and am on Chapter 5. Unfortunately it’s out of print now.

  5. 5 yo

    Since everything CHANGED on nov 4 2008, can we still look at things the old way?

  6. 6 pwm

    I’ve read the Smithers book, and have been following this ratio and derivations of it for several years. I think Smithers’ “ratio of a ratio” has the most predictive power. One thing I would also want to point out about it is that it is mean reverting. This is not bullish given how long and how far it has been above the mean. Andrew Smithers also has been putting out research recently that confirms this bearish reading.

    For those who have not read the book, I highly recommend it. It has exceptional rigor and clarity.

  7. 7 Mark

    The obvious concern is that the market is overvaluing current assets….i.e. given a deleveraging consumer, who doesn’t need/can’t afford as much stuff, excess capacity exists around the globe. So, why would you want to replace assets that aren’t needed?

  8. 8 Greg

    Some of the Fed’s line by line data on p.103 is questionable.
    E.g. line 3 shows real estate at market value for purposes of the denominator.
    I disagree that non-financial corp RE holdings can be worth 41% more in Q4 2008 than in 2004.

    More generally, the numerator is (by definition) marked-to-market, but the denominator’s correct valuation, uh, lags.

  9. 9 mitstop

    The Q could remain at .43 for years or go down to .30 and stay there for years. Big deal. Long term indicators provide foundational thought for long term long positioning in equities- that’s the extent of it.

  10. 10 roam92

    Is there any consideration with Q that the US economy has moved more towards service and technology, versus the smokestack manufacturing of the old days?

    In other words, the assets of information technology company (e.g., IP, people) might be reflected differently and mathematically undervalued on their balance sheet versus a factory with tangible assets and property.

    Just wondering if any allowance should be taken for this in looking at Q over the decades…

    Of course, as a previous commenter noted, a lot of things in the world have changed over the years - not just this.

    FWIW, Russell Napier (author, “The Anatomy of the Bear”) believes “Q Ratio Signals ‘Horrific’ Market Bottom

  11. 11 pwm

    The ratio has less near term predictive power the closer it is to its long term mean. Grantham at GMO uses a similar measure and is convinced that cyclical effects will dominate in the next couple of years.

  12. 12 Chris

    Roam: “assets of information technology company (e.g., IP, people) might be reflected differently and mathematically undervalued on their balance sheet versus a factory with tangible assets and property”

    Smithers talks about this in the book. In short, he refutes this view. The explanation revolves around the fact that historical returns on equity have been consistent as long as statistics are available, at 14% or so.

    Smithers claims that your contention is a fallacy of composition. Any given company may indeed have intangible assets that allow it to earn an above average return on equity. If the economy as a whole had substantially understated assets, then there should be evidence of higher returns on equity, which is not in evidence.

  13. 13 Babak

    badcompany, great minds think alike ;)

    mitstop, you’re right - which is why it is just one, among many indicators. For example, the Coppock Guide. You put it all together, stir and then take a sip.

    pwm, really? what does Grantham use?

  14. 14 papatse

    The new value of Tobin’s Q for June 2009 can be calculated
    table B.102, and dividing line 35 by 32. Since this equals about 0.64,
    should we take this as a bearish signal, since most deep recessions bottom
    out closer to a Tobin’s Q value of 0.3?

  15. 15 christian78

    Your discussion is around the signal of Q (bullish or bearish), but
    did someone ever question the mean of Q being way below 1?

    I am thinking of the market side: Q should be close to one or above, otherwise it can’t be an equilibrium if on average the market values the assets less than they are in the books, why should markets for these firms or even the firms themselves exist, as on average nobody believes in their (book) values?

    Isn’t that funny? Or am I missing out something here?

  16. 16 bsum

    please keep us updated with the quarterly Q values. Thanks!

  17. 17 Valentin

    Good article, cheers

  18. 18 Johan Lindén


    You are right that the mean Q isn’t 1. It is much less than 1 strangely enough.

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