There's value in Q

The idea of the Q ratio (often known as Tobin's Q) was first mooted by economist James Tobin in 1969. Its main assumption is that companies should be valued at their underlying net worth - that's to say their accounting net asset value. But here's the tricky part. Net asset value in this case is defined as the replacement cost of net assets.

'Q' can include or exclude corporate debt. In other words, the numerator of the ratio can either be enterprise value or market capitalisation. Tobin's original work included corporate debt, hence this version is usually known as "Tobin's Q". For the purposes of valuing the level of over or undervaluation of the stock market, however, we need to use so-called "equity Q", excluding corporate debt.

According to data from Smithers & Co - one of the main proponents of 'Q' - in June 2007 Q was 20% above the average value recorded since 1900. Since that time, the S&P500 has dropped by around 4%, so this would still suggest, if the market's replacement cost net asset value has remained unchanged, that the US market is still about 15% overvalued versus its long-term indicator. Smithers calculates the value of Q from published Federal Reserve data.

So the ratio is a basic measure of whether stockmarkets are in touch with reality. It seems to operate according to the well-established statistical principle known as reversion to the mean.

Egregious overvaluation

Q highlighted the egregious overvaluation reached by the market in both 1929 and 1999. The ratio peaked at 100% above its long-term average in 1999. The pattern of long-term trends in Q suggests that the ratio needs to move well below the long-term average before a revival can take place. This may take some time.

The downward adjustment in Q after the 1929 peak took until the late 1940s. So, on the same basis we can confidently predict the beginnings of a strong new bull market in 2019. Except that the degree of overvaluation in 1999 was greater than 70 years earlier, and so the process of correction may take even longer.

Needless to say, Q is not without its critics. One argument is that the economy is now much less dependent on physical assets to generate returns and much more dependent on intangible ones. Consequently, the old relationship between book assets and stockmarket value may not hold true. A short way of expressing this is, of course, that "it's different this time", a phrase said by jaundiced bankers and investors to represent the four most costly words in the English language.

The argument is a bogus one. Unless intellectual capital is genuinely created, all other forms of intangible assets usually arise as a result of acquisitions, in other words they are paid for out of a company's retained profits and hence are fully reflected in net asset value, which is itself merely the cumulative total of retained profits over the course of the company's life. Equally, if intangible assets have been acquired, this means they have been acquired from their old owner at more than their book cost.

The net effect of the transaction is to transfer the difference in book value - whether positive or negative - from the new owner to the old owner leaving the overall position of the corporate sector unaffected with no new value having been created.

Moreover, the genuine creation of intellectual capital by one company may well be to the detriment of the value of the intellectual capital and intangible assets of another. Cars decimated the sales of horse-drawn coaches, the invention of the word processor hit typewriter sales, personal computer sales affected mainframe computer sales, the launch of one type of software will affect sales of a competitor and so on.

All of these factors mean that Q is more valid for the market as a whole than for individual companies. But it is important nonetheless.

Peter says

Q is not an obscure piece of technical analysis. It is one of the touchstones of the market's true underlying value, based on objective data produced by the US central bank.

If it makes uncomfortable reading, then we need to question our own assumptions about where the market is headed. It doesn't prevent us from unearthing individual companies that are undervalued, but simply informs us about whether or not that value is being offered in the context of a market that may itself be, as at present, overvalued on this particular criterion.