Tobin Q Ratio

It’s easy to find what you’re looking for in the stock market, whether you’re a bear or bull. While there is still a bull case to be made in the short-term, I cannot ignore current valuations on an historical basis when making my investment decisions going forward. It appears that Warren Buffett agrees, as his personal portfolio currently contains at least 40% cash.

Let’s look at the Q ratio. The Q ratio, developed by Nobel Laureate James Tobin is an attempt to measure the fair value of the stock market using the Federal Reserve’s Z.1 data. The Q Ratio represents the total price of the market divided by the replacement cost of all its companies. On both an arithmetic mean and geometric mean, the Q ratio currently shows the stock market is more richly valued that at any time since 1900, other than 1998-1999.

At this time investors have to ask themselves if they’re willing to risk their gains over the last 6 years, on the chance that we have another 1998-1999 dot com valuations melt-up.

On the flip side, you have to ask yourself if you can live with watching a melt-up while mainly staying on the sidelines. If the markets break through their technical resistance levels at the top, that could very well happen.

That’s one reason it’s easier if you have some skin in the game and don’t completely divest yourself out of the stock market. Why have I? Even on the chance we have another style bubble, valuations have always come back to realistic levels. The higher the market goes from here, the further it crashes.

Stock valuations as a percentage of GDP are the highest they’ve been since 1999 suggesting limited upside potential going forward.

The trigger for a pullback could come from a furthering decline in growth forecasts. According to Thomson Reuters Data, U.S. growth is now estimated at 3.5 percent, compared with an Oct. 1 estimate of 11.2 percent.

Large U.S. multi-national companies including Caterpillar, Microsoft and Proctor and Gamble among others have pointed out that rising dollars are hurting profits. This is in turn prompting them to put renewed emphasis on cost cutting.

Internationally we’re still seeing slower growth in China along with slower growth and deflationary concerns continuing to linger in Europe.