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The Q Ratio Sends a Modestly Bearish Long-Term Signal

July 7, 2009

by Robert Huebscher

Strong market performance during the second quarter has claimed a victim.  Tobin’s Q ratio, one of the most reliable barometers of market valuation, is now 0.72 – up from its March low of 0.33 – indicating the market is modestly overvalued for long-term investors.

Over the short- and near-term the Q ratio indicates the market valuations are neutral.  For broad-based equity investors, though, the key to long-term performance is the price at which one enters the market.  As we noted in our March 31 article, the Q ratio has been exceptionally accurate – more accurate than the P/E ratio – in forecasting investors’ returns.

John Mihaljevic said that, in three of the five other instances since 1900 when Q increased to 0.72 or below, it was higher one year later. Four out of five times, it was higher three years after the initial increase. Looking five and 10 years out, it was higher in only one of five instances and unchanged in another.

The Q ratio gave similarly overvalued signals of 0.89 at the end of 2007 and 0.70 at the end of the third quarter of 2008, but had dropped to 0.55 at the end of 2008 and 0.61 and the end of the first quarter of 2009.

Mihaljevic is a former research assistant of the late economist and Nobel laureate James Tobin, the original developer of the Q ratio.  He now publishes the Manual of Ideas, a quarterly newsletter about the Q ratio and its implications for investors.