Is the market overvalued, undervalued, or just right?
Where is the market going? When attempting to chose individual equities I first like to decide on which sectors I believe will significantly outperform the S&P 500 over the next 12-24 months. After speaking to experts in the industry who attempt to pinpoint the current value of the market, I have come to the conclusion that the best way to value the economy is to use forward Price to earnings, Shiller’s Price to Earnings, and Tobin’s Q. In this post I am going to talk about Tobin’s Q, which is not a widely used tool in figuring out current market valuations. For those not familiar with the ratio, it was devised by James Tobin of Yale University in 1969. The ratio is calculated as the market value of a company divided by the replacement value of a firms assets.
Q Ratio= Total market value of a firm/total asset value
A low Q (between 0-1) indicates the replacement of a firm’s assets is much larger than it’s current stock value. If the Q ratio is high, it indicates the stock itself is more expensive than replacing the cost of its assets. Historically the markets Q ratio has ranged from .30 in 1923, 1930, and 1982 to a high of 1.82 in 2000 before the dot come bubble burst. Greg Mankiw, a professor of economics at Harvard University, has graphed the markets Q ratio since 1900. See the interesting chart below:
Currently Tobin’s Q is at 1.22 with momentum pushing it higher. Noting Tobin’s Q I believe the market is somewhat overvalued at these points and citing fundamental political issues in Europe and in the United States, I would begin to start taking money off the table and hedging myself by buying commodities and hard assets. Not sovereign debt.
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