The following letter is in response to our article last week, The Q Ratio Sends a Modestly Bearish Long-Term Signal.
Dear Editor,
How does the q ratio more than double from .33 to .72 when the market is only up 40% or so from March lows?
The one percent drop in the replacement cost does not account for the difference.
If the ratio is going to bounce from .32 to .72 on a 40 percent move in the market, how reliable is the indicator? Will it swing in a few months even if the market is flat? At least the market cap-to-GDP ratio does not seem to be subject to wide swings from judgments on replacement costs.
Tom Behlmer
NCGV Investment Consulting
Nevada City, CA
John Mihaljevic, who publishes the Manual of Ideas, a quarterly newsletter about the Q ratio and its implications for investors, responds:
Tom,
Thank you for your question. Tobin's Q is often approximated by analysts using book value as a proxy for replacement cost. Some analysts essentially calculate Q as the market value of equities divided by the book value of equities. However, this is an overly simplified and not very reliable way of estimating true Tobin's Q.
The Q ratio, as calculated under the method James Tobin and I used at Yale in the mid-1990s, does not rise and fall in a linear relationship with equity prices. In addition to the market value of equities, the Q calculation also includes a number of other variables, most of which are provided by the Federal Reserve in the quarterly Z.1 release. As Fed data is available only quarterly, the Q ratio at the market bottom in early March represents an estimate extrapolated from year-end 2008 Fed data.
A detailed explanation of the Tobin's Q calculation is provided following this letter. This spreadsheet contains Tobin's Q data going back to 1945. The spreadsheet also includes inputs used in calculating Q.
Please do not hesitate to contact me should you have any questions after reviewing the attached documents.
Sincerely,
John Mihaljevic, CFA
Managing Editor, The Manual of Ideas
