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Tobin’s Q: Valuation Back At Parity at Trader’s Narrative




Tobin’s Q: Valuation Back At Parity


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We recently looked at a valuation methodology from Ford Equity Research which suggested that right now, the stock market is approximately fairly valued.

Since the most recent components of Tobin’s ratio (also known as Tobin’s Q) have been released by the Federal Reserve, I thought we would check in on the updated chart for it:

tobins Q ratio chart update Jan 2010

If you’re not familiar with this method of valuation, you should read “Valuing Wall Street” by Smithers & Wright.

As you can see, this method of valuation is also suggesting that we are close to parity. The most recent data point is for June 2009 at 0.91 (which by the way, will probably be declared as the end of the great recession).

Since then, the S&P 500 has risen approximately 24% so we can guesstimate that the present Tobin’s Q ratio is slightly higher; perhaps even above 1. In contrast, the lowest Tobin’s Q ratio during the bear market was for January 2009 at 0.64. But that didn’t last long. Contrast this with the time period from 1974 to 1984 when it hovered around 0.40.

Finally, isn’t it interesting to see the same parabolic rise and blow-off pattern in this economic indicator that we see so often in stock and commodity markets? Probably the most important iteration of this technical formation was the gold parabolic climax in late 2009. The price of gold still has not recovered that level.

Here are some recent comments from David Rosenberg (of Gluskin Sheff) on valuation:

  • The median level of the S&P from our models is 970 based, on Q4 data inputs; and 1,120 based on Q1 estimates (based on credit spreads, earnings estimates/revisions, money supply and yield curve — credit spread improvement and yield curve steepening have had a big impact this quarter).
  • Based on the Shiller normalized P/E ratio, the S&P 500 is 27% overvalued presently. That would put fair-value at 840. Note, however, that on average, the final blowoff phase to rallies takes the degree of overvaluation to 50%, which would be 1,350 on the S&P 500.
  • On a Tobin Q replacement cost comparison, the S&P 500 is trading 22% above the long-run average. This would put fair-value at 890.
  • Applying what would be a normal earnings increase in the context of 5% nominal GDP growth for 2009 would imply $65 for operating EPS. Applying a typical one-year forward multiple of 15x on that earnings stream would generate a 975 fair value estimate for the S&P 500.
  • Technically, the market has just successfully broken through the 50% retracement level from the March lows — it did so at 1,120 on the S&P 500. Next critical Fibonocci retracement of 61.8% would imply a test of 1,225 on the index.
  • So we have a combination of valuation and technical factors that would imply a low of 840 and a high of 1,350. The S&P 500 is around the 1,150 mark so it is 17% shy of what could be construed as a bubble peak; and 27% away from what could be construed as a natural corrective phase after a parabolic move from an oversold bottom.

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7 Responses to “Tobin’s Q: Valuation Back At Parity”  

  1. 1 Daniel Eskin

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    Great article, really enjoyed reviewing Rosenberg’s comments. Do you focus on technical analysis for an overview of the market most of the time? I’m just starting to get myself acquainted with technicals such as the ones mentioned above since I traditionally have more of an economic background. Pretty random question but where do fundamentals and technical analysis meet in your opinion?

  2. 2 Ben

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    FWIW Andrew Smithers has been all over the media saying that according to Q valuations the stock market is currently 40-50% overvalued. Not sure where the discrepancy with this Q data comes from.

  3. 3 RB

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    I believe Smithers compares to a fair value for Q of around 0.63 (the long-term average), if I remember correctly.

  4. 4 JBR

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    Record Cash Means S&P 500 at Half its 2007 Valuation
    Jan. 19 (Bloomberg)

  5. 5 Ben

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    JBR the Q ratio accounts for the “record cash” alluded to since it is basically the book value of the entire market ex financials. RB here is the Smithers link

  6. 6 RB

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    Ben,
    The 0.63 number is mentioned here

    Why is q on Average Less than 1?

    Over the long-term, the average value of q is around 0.63. To work out the current degree of over or under-valuation, it is necessary to compare the value derived from the data in the “Flow of Funds Accounts” with this average.

    The long-term average value of q is below 1 because 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 major cause of over-valuation of assets is almost certainly due to their economic rate of depreciation being underestimated. (See Appendix 1 Report 180 “A Monthly Proxy for q Using S&P 500 Data.”, Report No. 289 “Intangibles: Issues for Profits, Asset Values and Depreciation.” and Chapter 17 of Wall Street Revalued.)

  7. 7 Ben

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    RB-
    thanks for getting back to me. We’ve probably wasted more time on this then its worth because stocks aren’t cheap either way. I wish Smithers would make up his mind though. FWIW Jeremy Grantham just said he places fair value around 950 and he gave Smithers a blurb on Valuing Wall Street.

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