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Business News/ Market / Stock-market-news/  Nobel winner James Tobin’s math shows S&P 500 far from reality
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Nobel winner James Tobin’s math shows S&P 500 far from reality

Tobin's Q ratio shows equities in the US are valued about 10% above the cost of replacing their underlying assets

Valuation tools are being dusted off around Wall Street as investors assess the staying power of the bull market that is now the second longest in 60 years. Photo: Getty ImagesPremium
Valuation tools are being dusted off around Wall Street as investors assess the staying power of the bull market that is now the second longest in 60 years. Photo: Getty Images

New York: If you sold every share of every company in the US and used the money to buy up all the factories, machines and inventory, you’d have some cash left over. That, in a nutshell, is the math behind a bear case on equities that says prices have outrun reality.

The concept is embodied in a measure known as the Q ratio developed by James Tobin, a Nobel Prize-winning economist at Yale University who died in 2002. According to Tobin’s Q, equities in the US are valued about 10% above the cost of replacing their underlying assets—higher than any time other than the Internet bubble and the 1929 peak.

Valuation tools are being dusted off around Wall Street as investors assess the staying power of the bull market that is now the second longest in 60 years. To Andrew Smithers, the 77-year-old former head of SG Warburg’s investment arm, the Q ratio is an indicator whose time has come because it illuminates distortions caused by quantitative easing.

“QE is a very dangerous policy, in my view, because it has pushed asset prices up and high asset prices, we know from history, are very dangerous," Smithers, founder of Smithers and Co. in London, said in a phone interview. “It is very strongly indicated by reliable measures that we’re looking at a stock market which is something like 80% over-priced."

Dissenting views

Acceptance of Tobin’s theory is at best uneven with investors such as Laszlo Birinyi saying the ratio is useless as a signal because it would have kept you out of a bull market that has added $17 trillion to share values. Others see its meaning debased in an economy whose reliance on manufacturing is nothing like it used to be.

To Smithers, the ratio’s doubling since 2009 to 1.10 is a symptom of companies diverting money from their businesses to the stock market, choosing buybacks over capital spending. Six years of 0% interest rates have similarly driven investors into riskier things like equities, elevating the paper value of assets over their tangible worth, he said.

The Standard and Poor’s 500 Index rose 0.3% at 4pm in New York, closing at a record for a third straight session.

Members in the benchmark gauge last year spent about 95% of their profits on buybacks and dividends, with stock repurchases exceeding $2 trillion since 2009, data compiled by S&P Dow Jones Indices show.

In the first four months of this year, almost $400 billion of buybacks were announced, with February, March and April ranking as three of the four busiest months ever, according to data compiled by Birinyi Associates Inc.

Slow spending

Spending by companies on plants and equipment is lagging behind. While capital investment also rose to a record in 2014, its growth was 11% over the last two years, versus 45% in buybacks, data compiled by Barclays Plc shows.

With equity prices surging and investment growth failing to keep pace, the Q ratio has risen to 58% above its average of 0.70 since 1900, according to data compiled by Birinyi and the Federal Reserve on market and asset values for non-financial companies. Readings above 1 are considered by some to be too high and the ratio has exceeded that threshold only 12% of the time, mostly between 1995 to 2001.

That’s nothing to be alarmed about because the American economy has become more oriented around services than manufacturing, according to George Pearkes, an analyst at Harrison, New York-based Bespoke Investment Group LLC.

Nowadays, companies like Apple Inc. and Facebook Inc. dominate growth, while decades ago, it was railroads and steel makers, which rely heavily on capital.

Mean reversion

“Does that necessarily mean that the Q ratio should be as high as it is right now? I don’t know," Pearkes said on phone. “With those sorts of long-term indicators, they can sometimes mean that the market is overvalued. But the reversion to the mean on them is usually going to take a lot longer than most people’s time frame."

Investors who based their investment decisions on the Q ratio would have missed most of the rally since 2009, according to Jeffrey Yale Rubin, director of research at Birinyi’s firm. The measure rose above its historic mean three months into this bull market and since then, the S&P 500 has climbed 131%.

“The issue we have with Tobin Q is that it does a very poor job at timing the market," Rubin said from Westport, Connecticut. “The followers of Tobin Q never told us to buy in 2009, yet now we are warned that we should sell. Our response is sell what? We were never told to buy."

Bond yields

Everyone from Janet Yellen to Warren Buffett has spoken cautiously on stock valuations in the past month. Both the Fed chair and chief executive officer (CEO) of Berkshire Hathaway Inc. said prices are at risk of getting stretched should bond yields increase. The rate on 10-year treasuries slipped last week to 2.14%, while the S&P 500 gained 0.3%.

“It’s probably a sensible configuration for the stock market to be overvalued because competing investments are so poor," Robert Brusca, president of Fact & Opinion Economics in New York, said on phone. “As an investor, you’re not just looking at the value of the firm, but the value of the firm relative to other things you can do with your money."

At 2,260 days, the bull market that began in March 2009 this month exceeded the 1974-1980 rally as the second-longest since 1956. While measures such as price-to-earnings ratios are holding just above historical averages, the bull market’s duration is sowing anxiety among professionals who watched the previous two end in catastrophe.

“We’re still close enough to that prior experience and that hold-over effect is still there," Chris Bouffard, chief investment officer who oversees more than $10 billion at Mutual Fund Store in Overland Park, Kansas, said on phone. “When you start to see prior cycle peaks on the chart like Tobin Q and any other valuation metrics that people are putting up there, it looks dramatic, stark and scary." Bloomberg

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Published: 19 May 2015, 11:56 AM IST
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