March 31, 2009
Over the past several decades, this strategy would have produced a compounded annual rate of return of several percentage points higher than the S&P 500 Index.
Mihaljevic is confident that Q will reach extreme levels. The ratio hit a low of 0.29 twice over the course of the past century — in 1948 and again in 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949. Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.43 is very bullish if Q is on the upswing, but when Q is in decline, a value of 0.43 is only modestly bullish.
Those who say the current Q Ratio is an extremely bearish sign, meanwhile, are missing three key points, Mihaljevic says:
- “Attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns.”
- “The relationship between Q and stock prices is not quite linear. We estimate that a 50% drop in Q from current levels would be accompanied by a one-third drop in stock market indices.”
- “Replacement cost, the denominator of the Q ratio, has increased each year since 1946.”
Mihaljevic notes two reasons why critics contend the Q ratio may be losing predictive value. The US economy has become increasingly service-oriented and driven by intellectual property, and the Q ratio does not consider the replacement cost of intangible assets. Those critics should recall, however, that the Q ratio reached excessively high levels at the peak of the Dot Com bubble.
Others contend that the economic rationale behind the Q ratio is sound, but the underlying adjustment mechanism may take longer than most equity market investors can tolerate. Mihaljevic agrees, and he does not advocate using the Q ratio as a short-term market timing tool. When the Q ratio reaches extreme levels (below 0.40 or above 1.50), however, he says it offers meaningful predictive insights for long-term investors.
Although he has never (to our knowledge) explicitly cited the Q ratio, Warren Buffett implicitly embraces the concept. Buffett advocates investing in businesses with “wide moats” – companies that have created defensible barriers to entry, making it difficult for existing or potential competitors to replicate their business model. The cost of replacing such a business would be relatively high, and therefore it would have a low, attractively valued Q ratio.
For more information on the Q ratio, see John Mihaljevic’s web site, the Manual of Ideas.
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