Tobin’s Q Ratio Says Equity Bottom Much, Much Lower

A story on Bloomberg, “Q Ratio Signals ‘Horrific’ Market Bottom, CLSA Says,” argues that the global equity market bottom will be well below the recent lows, but also thinks we may not see it until 2014 as the current pump priming measures hold off deflationary pressures for a while.

Note that Gary Shilling, who was in a decided minority in focusing on deflation risk, says we have deflation now and is more bearish near-term, since once deflation has taken hold, it is hard to shake (hat tip reader Vijay).

From Bloomberg:

A global stock slump may have further to go, according to Tobin’s Q ratio, which compares the market value of companies to the cost of their constituent parts, CLSA Ltd. strategist Russell Napier said.

The ratio, developed in 1969 by Nobel Prize-winning economist James Tobin, shows the Standard & Poor’s 500 Index is still too expensive relative to the cost of replacing assets, said Napier. While the 39 percent drop in the index this year pushed equity prices below replacement cost, history suggests the ratio must sink further as deflation sets in, he said. The S&P may plunge another 55 percent to 400 by 2014, Napier said.

“The Q has come down to its average, however it’s not always stopped at the average,” said Napier, Institutional Investor’s top-ranked Asia strategist from 1997-1999. “It has tended to go significantly below that in long bear markets.”…

Napier, who teaches at Edinburgh Business School and advised clients to buy oil in 2002 before it tripled, based his S&P 500 forecast on the Q ratio for U.S. equities as well as the 10-year cyclically adjusted price-to-earnings ratio, another measure of long-term value.

Before the trough in 2014, investors are likely to see a so- called bear market rally for the next two years as central bank actions delay the onset of deflation, Napier said.

“In the long run, stocks will become even cheaper,” said Brian Shepardson, who helps manage $1.9 billion at Xenia, Ohio- based James Investment Research. The firm’s James Balanced Golden Rainbow Fund beat 98 percent of similar funds this year. “There’s a likelihood of some type of rally and further pullback surpassing the lows we’ve already set.”

The Q ratio on U.S. equities has dropped to 0.7 from a peak of 2.9 in 1999, and reaching 0.3 has always signaled the end of a bear market, said Napier, 44, the author of “Anatomy of the Bear,” a study of how business cycles change course. The Q ratio for U.S. equities has fluctuated between 0.3 and 3 in the past 130 years.

When the gauge is more than one, it indicates the market is overvaluing company assets, while a Q ratio of less than one signifies shares are undervalued …

At the end of the four largest U.S. bear markets in 1921, 1932, 1949 and 1982, the Q ratio fell to 0.3 or lower, and history is likely to repeat, said Napier. From the 1982 trough, the S&P 500 grew more than 14-fold to the middle of 2000, when Napier says the last bull market ended….

Federal Reserve Chairman Ben S. Bernanke’s indication that he will use “quantitative easing” to prevent deflation points to a stock market rally that may last for the next two years, Napier said. With quantitative easing, a tool pioneered by the Bank of Japan, central banks can stimulate inflation by printing money and flooding the market with cash in order to encourage consumers to spend.

The government’s efforts will eventually fail as ballooning government debt devalues the dollar, causes investors to flee U.S. assets and takes the S&P 500 to its eventual bottom in 2014, Napier said.

“Bear markets always end for exactly the same reason, and that is the market begins to price in deflation,” he said. “Equities will be incredibly cheap.”

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  1. Max

    With quantitative easing, a tool pioneered by the Bank of Japan, central banks can stimulate inflation by printing money and flooding the market with cash in order to encourage consumers to spend.

    So, ndk, doesn’t this fact contradict your claim that there is no such thing as a pure printing press?

    You clearly got in over your head, and forgot that money can be printed. It’s nothing but digits, after all.

  2. Carlosjii

    like when the price of an ounce of gold will buy the Dow – that is if anyone is still taking US dollars for anything then.

  3. Anonymous

    "The government’s efforts will eventually fail as ballooning government debt devalues the dollar, causes investors to flee U.S. assets and takes the S&P 500 to its eventual bottom in 2014, Napier said."

    Aren't other countries' governments also increasing their debt? Isn't this focusing on the US but ignoring what is going on in other countries at the same time?

  4. Don

    Napier’s analysis seems to correlate high inflation with a very low TQ. He’s basing the correlation on the years in the US from say 72 to 81. He’s claiming that we’re going to have high inflation going forward because of the quantitative easing by the Fed.

    It’s an interesting correlation, but there needs to be more of an explanation in order to understand if that correlation is useful now.

    Don the libertarian Democrat

  5. Bob_in_MA

    Napier’s book (anatomy of the Bear)is great if anyone hasn’t read it. It doesn’t try to market-time the way those quotes make him sound.

    He looks at four super-bear bottoms, 1921, 1932, 1949 and 1982 and shows what they had in common:

    – very low Q, like .3

    – market bottom roughly coincided with economic bottom (contrary to oft-repeated common wisdom),

    – bonds rally just before stocks

    – commodities and auto sales recover before stocks

    – cyclically adjusted p/e is very low, but in a range

    In the book, written several years ago, he predicts a bottom between 2009 and 2014 just based on the average lengths of bear markets in the past.

    I’m not sure I agree with his quote in the Bloomberg article that central banks can postpone deflation.

  6. Tortoise

    Tobin’ Q can predict stock market prices? Color me skeptical. It certainly appeals to the rational side of Homo Sapiens but markets are inherently irrational and unpredictable, not to speak of manipulated through fiscal and monetary policy.

    In fact, if Q is 0.7, the market is “undervalued” so presumably the rational thing is to buy. But, it is argued that it will go down to 0.3 because that is what happened in the past… Maybe someone can explain this point to me because I cannot comprehend it rationally.

    I suggest that we may know the market value of a company (numerator) but the book value (denominator) is an accounting entry which may have little to do with replacement cost. How do you value brand names, patents, or resources in the ground?

    By the way, when the Q is high, public companies should be selling stock and when Q is low they should be buying it back. Guess what, the opposite happened in the last cycle.

  7. tyaresun

    I second Tortoise. How the heck did they calculate the replacement cost? Did they use the book value as proxy?

  8. Sion

    I posted this in the wrong tread earlier sorry.

    I’ve had a theory for a while now that goes like this.

    There obviously needs to be an intergenerational wealth transfer. The boomers are essentially selfish so they’ll try to keep as much as possible for as long as possible.

    Unfortunately their market is much smaller then their supply. We saw equity heights reached as boomers flooded through the system bebinning in 1980’s. We will see equity lows as boomers roll out the other end.

    Why the lows? Because the market is younger productive people who are earning but can’t afford the Boomer asetts. The prices must drop. Especially because the boomer boom was massively credit fueled.

    Of course massive wage price increases would achieve the same thing.

  9. Anonymous

    I see the blame the boomers idiot is on this thread when I responded to him in the last…what a fool.

    I want to politely disagree with the analysis presented here about the future of the market out to 2014. While the analysis may make sense if you isolate the US economy, I think it is wrong to do so and does not see this event we have entered as the black hole singularity that it is. I think anyone who thinks they can model the outcome of the next 5 years is smoking some real good shit and it is too bad they are offering it to others.

    I agree with your position NDK and appreciate your contributions as well as the posting by Yves.

    Those that don’t study and learn from history are destined to repeat it.

  10. Anonymous

    Disclosure: I subscribe to Gary’s INSIGHT – and made a nice 40% gain this year by following his advice and buying long Treasuries.

    Shillings analysis available to INSIGHT readers is undeniable. I’ve studied it for a few years now, haven’t found any significant flaws, have profited from it, and see the evidence everywhere.

    If you look at the post war 20th century (our lifetimes) in a historical economic context, you see it was a really unusual period of (inflationary) wars. And you can see how since the cold war it’s been winding down, and that deflation is the final result. Which isn’t necessarily a bad thing.

    But it never ceases to amaze me how people will continue to deny the self evident truth.

  11. Anonymous

    Sy Krass said…

    Yeah if the government didnt intervene we would have massive deflation going on now. More so than already exists. And yeah, we could hyperinflate and the stock market could go through the roof unnaturally. And THEN the market could crash again and we would finally be at a bottom.

  12. bg

    “I second Tortoise. How the heck did they calculate the replacement cost? Did they use the book value as proxy?”

    You can read the book. I am not an expert, but the reason the Q falls below 1 is not because of overshoot, it is because of overcapacity. How much is an idle factory worth compared to its replacement cost? Book value is depreciated, so I think you have to look at going rates.

    I am old enough to remember 1980-1982. Taking a claim on future earnings of U.S. companies didn’t feel like a good strategy at the time. Everyone was just doing the minimum. With the 70’s calamities in recent memory (inflation, campus riots and gas lines) few were doing the buy-and-hold/hope.

    Professors were talking up LBO’s profitably being able to profitably buy for asset liquidation, but there was little of even that.

    we have not seen the same level of loss-of-confidence, traumatization, and reflexive conservativism in the real economy yet. Q=.3 is a radical, but plausible outcome – over years.

  13. Richard Kline

    So Bob_in_MA, yeah, as Napier has it: when the real economy finds its real floor and starts to recover, the financial economy rides the tide up. . . . Just as it’s always been. Government confidence tricks with low rates and other jiggery-pokery mask the fundamental process, but it is always the real economy which leads recovery.

    —And our real economy REALLY SUCKS. That is the real problem: we need to make up for thirty years of disinvestment in our country in favor of speculation. Changes of this scale don’t get done overnight, or in one Administration, and stimulus is largely beside the point. Stimulus is life support but it won’t lead to much real growth, just brake the downswing, which may in fact be counterproductive if the point is to make a buildable bottom in real terms.

  14. Sion

    I’m sorry my post above was so unoriginal. And yes I agree the rest of the world is a large place and demand can occur from anywhere within it.

    One of the things I find interesting about discussions about economics is that they can kind of fractal in nature.

    They can be incredibly broad and simple or incredibly detailed and complex and still reach the same conclusion.

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