16 February 2009

Tobin's Q

In their book “Valuing Wall Street”, Andrew Smithers and Stephen Wright use James Tobin’s Q ratio (the value of a stock market divided by corporate net worth), to recommend (in 2000) disinvesting from equities. They also give an excellent account of the dynamics of the economic cycle.

According to their lucid arguments, the rise in the value of stock markets and other asset classes above their historic averages is accompanied by changes in expectations, which leads to increasingly unrealistic beliefs about the future.

Each era may have a specific set of aggravating circumstances which feed these beliefs. Smithers and Wright draw attention to the “wall of money” from overseas and the practice of corporations purchasing their own equity in support of ill-advised share option schemes 1 as particularly egregious causes. If they were writing more recently they might have been tempted to add the enormous expansion of unregulated markets and the growth in the balance sheets of banks.

Whatever the proximate causes, increases in stock market valuations make it increasingly attractive for corporations to raise funds through the sale of equity. In other words, when the stock market is high, the cost of equity is low. This makes otherwise unprofitable investment possible. This is over-investment, clear and simple.

So, an over-valued stock market acts on prices in a similar way to interest rates that are kept too low. They are both likely to be inflationary. 2 3

However, a mis-priced stock market tends to have more damaging effects than mis-priced interest rates, because, unlike with interest rates, those changes are necessarily accompanied by changes in long-term expectations about values. Increases in the value of assets not only make people feel richer, but make them more optimistic about their future wealth, too. This leads them to be less conservative in their saving and to increase current consumption.

So, an over-valued stock (or any other) market both increases investment and reduces savings. This is doubly inflationary and it is ultimately self-limiting. However, in circumstances where an external source of funds is available, the correction can be delayed. And, of course, America’s current account deficit has provided such a source for a number of years.

In such a case, changes in inflationary expectations and a rise in interest rates need not burst the bubble, as happened in the late 1960s or the early 1980s. Instead, it can be caused by a change in sentiment about the viability of investments, as happened in the 1930s—and is clearly happening now. 4

Once this change in sentiment takes place, all the effects that were previously working together to stimulate the economy go into reverse. The cost of raising equity increases, banks attempt to repair their balance sheets, businesses and individuals likewise attempt to reduce their borrowings, and the economy is in danger of going into a spiral of debt deflation, as was first described by Irving Fisher in the 1930s.

In this context, attempts to stimulate the economy are likely to be of limited effect. Post-bubble economies do not generally respond quickly to reductions in interest rates or increases in government expenditure.

Smithers and Wright failed to anticipate the insanity of the real estate bubble that succeeded and lengthened the stock market bubble, but they were pretty much spot on in their analysis of what would be likely to follow it.


Valuing Wall Street by Andrew Smithers and Stephen Wright. McGraw Hill, 2000.

1 “household and overseas investors have increasingly, and sensibly, been net sellers of stocks…corporations have simultaneously switched to being net buyers, despite the fact the, in order to do so, they have had to raise additional, and far from cheap, financing. If this seems more than slightly crazy, it is…the fact that it has been allowed to happen may well appear, after the greatest bubble of the twentieth century has broken, to have been one of the greatest follies of the twentieth century.” [151-2]

2 “Equity is not the only form of capital; clearly bonds and bank lending are also important. Equity is, however, the most fundamental. Companies and individuals can finance themselves wholly with equity, but they cannot finance themselves wholly with debt…popular discussion of economics tends to assume that the impact on economies of changes in interest rates is far more important than the impact of changes in the stock market. This is doubly unfortunate, because the level of the stock market not only determines the cost of equity capital but also influences the availability and thus the cost of borrowed capital.” (p.331)

3 “When the stock market is strong, most banks and other lenders are inclined to treat the rise in share prices as a permanent increase in real wealth rather than a temporary fluctuation. The result is that lending expands with rising stock markets, which thus has a double impact on reducing the cost of capital. Hence high stock markets reduce the cost of finance, even if no equity is raised, simply by making debt more easily available.” [p.332]

4 “Because there is a significant risk of deflation in the next recession, the coming bear market might resemble that of the 1930s more than the 1970s. Of course there is no guarantee of this. Inflation may neither pick up nor become significantly negative, but simply remain subdued. In these circumstances, it is likely that the Federal Reserve, just like the Bank of Japan in recent years, would push short-term rates down very close to zero.” [p.181-2]

Smithers and Wright are pretty scathing of a variety of investment methods. for example, they describe portfolio insurance as “a prime example of that rare but interesting combination: an exceptionally clever idea that is at the same time an exceptionally stupid idea.” [p.188]

For anyone interested in their view on investing, their book is recommend, but they can be summarized in a few words:

Return on equity has been relatively constant over a very long period of time at about 6.5%. Because of this, there is no reason to expect departures from this figure to continue indefinitely and we can expect returns to revert to the mean. We can therefore say with a high degree of certainty that if the ratio of stock market value to net worth (i.e. Q) is above its long-term average (i.e. approximately unity), then a stock market is over-valued.

The long-term measured average for Q for the US stock market is approximately 0.6 (not unity, as might be expected in theory); it peaked in 2000 at about 1.8; and in early 2009 it is about 0.76, still above its average and well above previous bear market bottoms of around 0.3.

A sensible approach to investment, is to sell stocks when Q rises somewhat above its long-term average and to purchase them again when Q returns below its long-term average. As an example, using a Q of 1.0 as a sell signal and a Q of 0.5 as a buy signal, would have caused an investor to liquidate stocks in the mid-60s returning in the mid-70s and to liquidate again in the mid-90s.

To measure Q, download the latest Flow of Funds Accounts of the United States from the federal Reserve. Use the table “B.102 Balance Sheet of Nonfarm Nonfinancial Corporate Business” and divide line 35 “Market value of equities outstanding” by line 32 “Net worth (market value)”

d. sofer