The Q Ratio is a method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but rough to calculate. It's basically the total price of the market divided by the replacement cost of all its companies. It's history looks something like this:
Calulations: Doug Short
The idea here is that if it’s cheaper to build a factory instead of buying a competitor, the factory will eventually get built by someone. If not, the competitor gets bought. These two rational actions take the ratio back to the average over time.
So, what can you do with this? As I’m writing this, I haven’t looked at any DJIA quotes yet. So here’s a theory: buy when the ratio < .4 and sell when it’s >1. Let’s see what that gets us. I’m eyeballing this and am rounding to the beginning of the next year, thinking ratio is probably not available in real time.
Buy 1/1/1919, Sell 1/1/1930 (DJIA: 83 – 244)
Buy 1933, Sell 1936 (60 - 144)
Buy 1947, Sell 1969 (176 – 948)
Buy 1974, Sell 1994 (855 – 3820)
Buy when ??? (would have been out of the market for 17 years and counting ...)
The math, going back to the first buy in 1919:
$1 turns into $170 using the Q-ratio to time the market.
$1 turns into $46 if you just let the $1 ride from 1919 to 1994.
$1 turns into $144 if you let it ride from 1919 until today (Dow 12,000)
$170 is better but not radically different than $144 but there has been lots of down time over that period (36 years), during which (in our little experiment) you would be holding nothing. That doesn’t really seem fair to the test. It seems like the two most logical replacements for stocks are bonds and gold. Considering the last 17 years, if you let me buy a bond index in 1994 with my $170, the final result changes to $483. Gold changes $170 to $531. If you let me buy gold every time I sell the DJIA for the entire period, my $1 turns into $1,360 and there are no periods in aggregate that I lose money.
Woah.
The boxed figures are the invested periods.
So, this seems pretty simple but would have worked amazingly well for the last hundred years. This overall conclusion seems especially dramatic when considering we would have sat out the bull market of the 1990s and still had spectacular results. Why doesn’t this get more publicity? This is a serious question, why is this basically the first time I’m hearing about this?
I think what is the most scary about the current position of the chart is that in all other cases, when the ratio crossed the average in the past, it’s momentum ultimately took things much further. The “bounce” off the average in 2008 is pretty unusual at this point. Did government intervention stop the fall? That seems possible. Is the final outcome yet to come? That seems possible.
With a Q-Ratio of 1.17, is the market a clear sell at this point? If not, what could the reasons for it not to be? In other words, why would we think things are different this time?
Here’s a recap of some of the things I said in 2010:
I cited upcoming demographic changes and deleveraging and sold quite a bit in April of last year when the Dow was around 11,000. The timing looked really good on that for a while as the Dow dropped 1,000 points, but is now up to 12,000. I still think 12,000 is ridiculous; it’s coming down. But at this point, this has cost me some money.
I had four other ideas, some that I acted on and some that I didn’t.
Sell Emerging Markets (push)
Rebalance toward Domestic (win)
Tilt toward small caps (would have been a win, I didn’t do it)
Japan (would have been a loss, I didn’t do it)
I also have been thinking a lot about “buying what you like” which by that I mean buy the stocks of those companies who you like in real life. I think my rule there is when a company has competitors but you don’t even investigate them before buying, then it’s time to buy the stock. My list is:
Apple
Netflix
Bank of America
Southwest
Panera
4 of these 5 would have been big hits going back to when I personally started liking each of these, with the exception of Bank of America, depending on the timing. So having said this, I don’t have any specific ideas at this point but I’m going to keep my eyes open.
What’s up bitches, knucklehead here. Thought we could review where we stand after 2010.
A couple notes on the overall market: Wilshire 5000 is now up 100% of its low. S&P recorded a 12% gain for the year. All in all pretty good, and not the meltdown I somewhat suspected.
My YTD performance was 6.25% vs. S&P’s 12%. The underperformance is largely a function of the cash sitting around and also an investment of a quarter of my portfolio in a private investment which at this point I’m marking as “even” for the year. I wanted to be conservative, I was, and my returns are muted. That was the plan I guess so it’s hard to feel too bad about it. My stock picking did cause me to lose a little ground, here’s the breakdown:
Return on Equities: 11.01% (hello, EMH)
Return on Equities and Bonds: 9.64%
Return on the above plus company stock and cash: 8.17%
Return on the above plus private investments: 6.25%
Here’s a rundown of the actual investment choices I made vs. the S&P:
Gold (GLD): 9.1% (i.e. outperformed the S&P)
Singapore (EWS): 8.4%
Large Growth (VIGRX): 3.6%
Emerging Markets (VEIEX): 0.7%
Int’l Growth (VWIGX): -0.6% (i.e. underperformed the S&P)
Bond Index (VBMFX): -3.8%
Energy (VGENX): -5.6%
Agriculture (MOO): -10.3%
Pot (POT): -15.47%
I no longer own Gold, Energy, Bonds, MOO, POT. For anyone that follows POT, you are probably wondering how I lost money on this one. Here’s the chart. Guess which day I sold.
Get a load of this:
I mean, seriously? This shit ain't easy, man.
So, I’ve got some winners and some losers. I’m really starting to conclude this stock picking stuff is for the birds and am starting to wonder why I’m doing it.
So, back to the macro level. Overall, I’m still pretty pessimistic. So I plan to stay pretty conservative but I also have a large tax credit from a previous sale that I would love to “soak up” in 2011 with some gains. So I’m a little conflicted there. I’m also conflicted due to the fact that it’s hard to fight the government, and by that I mean QE2, QEs 3-10(!), etc. and next year being the third year of Obama’s first term. Third years are usually pretty darn good.
So my strategy is going to start simplifying things but keep a toe in the water. I recently sold some stuff as mentioned above and have the cash lying around, I think it’s time to lob most of that at my mortgage. I just can’t get excited about a single thing. Equities are look overvalued, Bonds are arguably a bubble, and gold is ridiculous. I’m currently looking into crystal meth futures, I will let you know how that pans out.
Here’s where we're leaving things:
Later kids.
Calulations: Doug Short
