Tobin's Q ratio is extensively used by analysts, including Andrew Smithers from Smithers and Co in London. The ratio was originally devised by Yale economist James Tobin and suggests that the combined market value of all the companies on a stock market should roughly equal their replacement cost or asset replacement value.
Q ratio = total market value of company / total asset value
If the stock market produces a value of less than one, according to this measure, the cost to replace companies' assets is greater than the market ascribes to the value of their shares, which suggests that the company/market is undervalued.
The Q ratio for US equities has moved between 0.29 (1921, 1932, 1949, and 1982) and 3 (1999) over the past 130 years – over the long-term, the average value of Q is around 0.63. It's currently 0.43 (as of 15 March) according to Tobin's research assistant and current guardian of the US Q ratio measure, John Mihaljevic, he reckons the ratio had only been this low on six other occasions since 1900 and he regards himself as "modestly bullish".
Could it get worse? At the end of the four largest US bear markets in 1921, 1932, 1949 and 1982, the Q ratio fell to 0.3 or lower, so even if markets collapse it probably hasn't got much further to fall. Mr Mihaljevic's relative optimism was recently echoed by bond supremo Bill Gross, CIO of PIMCO, who said "today's Q ratio has almost never been lower, and certainly not since WWII, implying extreme undervaluation". Not everyone who uses this measure is quite as optimistic, though. Russell Napier, a strategist at Asian broking house CLSA, has come to a rather different conclusion suggesting that current low levels support his expectation of a "horrific" market bottom and a further drop of 55 per cent in the S&P 500 by 2014.
But is the Q ratio actually any good at predicting future returns? The evidence suggests that it is. In a 2003 paper, Duke University researchers Matthew Harney and Edward Tower looked at all the value-based ways of measuring the market. In particular they tested the Q ratio against CAPE – and in virtually every time frame the Q ratio proved successful with the use of a 30-year CAPE coming second in terms of predictive power. Mr Mihaljevic himself has looked at which measure works – he found that the best strategy was to buy when the Q ratio was below 0.40 and sell when it was above 1.00. 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.
There are some big caveats that are worth bearing in mind when using the Q ratio. The first is that the measure may be beginning to lose its predictive value because of profound changes in the US economy as more business moves to the service-based economy – the Q ratio does not consider the replacement cost of intangible assets. And like many of the measures discussed here Mr Mihaljevic doesn't think the Q ratio should be used as a short-term market timing tool. Note, though, that Q ratios can only be used for the US and can't be used for individual companies.
■ Prognosis: Positive or modestly bullish.
