The Q Ratio Indicates a Significantly Overvalued Market
by ilene - September 20th, 2010 11:15 pm
The Q Ratio Indicates a Significantly Overvalued Market
Courtesy of Doug Short
Note from dshort: The charts below have been updated based on the September 17th Federal Reserve Flow of Funds release for Q2. I’ve also used the Vanguard Total Market ETF for extrapolating the Q Ratio up to the present.
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.
The first chart shows Q Ratio from 1900 through the first quarter of 2010. I’ve also extrapolated the ratio since June based on the price of VTI, the Vanguard Total Market ETF, to give a more up-to-date estimate.
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 1.82 — 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…