Q-Ratio

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?