Tobin's Q No Longer Bullish on U.S. Equities
We estimate that Tobin’s Q increased from a March low of 0.33 to 0.72 as of June 26, roughly in line with an adjusted average of 0.71 for the period from 1900-2009. Our data shows that while Q declined sharply in 2008, it has increased from 0.55 at yearend 2008 and from 0.61 at the end of 1Q09. The numerator (market value) and denominator (replacement cost) of the Q ratio were up 11% and down 1%, respectively, in the first quarter.
Today’s Q ratio sends a neutral near-term and medium-term market signal, and a modestly bearish long-term market signal. Of the five other instances since 1900 when Q increased to 0.72 or below, it was higher one year later in three instances. Four out of five times, it was higher three years after the initial increase. Five years and ten years after the increase, it was higher in only one of five instances and unchanged in another instance.
Replacement cost declined 0.7% sequentially in 1Q09, a reversal from a sequential increase of 0.3% in 4Q08, reflecting deflationary forces at play in the U.S. economy, including rising unemployment, home price erosion, and financial deleveraging. We note that replacement cost has not recorded a full-year decline in any year since at least 1900. Further declines in replacement cost would therefore be very significant in a historical context. We will watch the recent deflationary trend closely, but we do not anticipate that replacement cost will in fact decrease for the full year 2009.
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Equities and Tobin's Q, by John Mihaljevic, CFA, June 28, 2009
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