March 31, 2009
Currently, the Q ratio is very close to historical bottoms that have corresponded to beginnings of bull markets. At the beginning of March, it reached a low of 0.33, at which point Mihaljevic was strongly bullish – a sentiment that was justified by the ensuing 20% rally.
Since 1900, the average Q ratio has been 0.78, and at the beginning of 2008 it was 0.89, declining to 0.55 at the end of last year.
In a 2003 paper, Duke researchers Matthew Harney and Edward Tower showed that the Q ratio offered superior value, as compared to all variants of the P/E ratio, in predicting rates of return over alternative time horizons. They tested the Q ratio against P/E ratios using 30-, 20-, 10-, 1-year moving-averaged earnings. Predictive ability was measured by comparing Q ratio values to subsequent rates of return on the S&P 500 index and ranking the results by R-squared. Incidentally, 30-year P/E ratios offered the second-best predictive value, followed in order by 20-, 10- and 1-year values.
Mihaljevic explored this question further, evaluating predictive value using three different methods for computing the Q ratio. He found that the best strategy was to buy when the Q ratio was below 0.40 and sell when it was above 1.00, as shown in the graph below:
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