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The big Q about US stocks

Why do you invest? Is it for profit or for loss? Those may seem like questions with obvious answers. But if, like most investors, you own US stocks at the moment then you should expect to lose money over the next decade. A little known but reliable measure, known as the q ratio, is at its second highest level since 1900. It’s just another reminder that US stocks are extremely overpriced and should be avoided.

Let’s deal with the easiest bit first. Second quarter earnings in the US are set to fall the most since 2009. Year-on-year, Factset says expectations are for a fall in top line revenue of 4.4% and a drop in profits of 4.7%. That would mark the second consecutive quarterly revenue decline.

This is not the stuff that investor dreams are made of. Especially when everything says that US stocks are expensive. I’ve looked at various measures of market valuation in the past. Today it’s the turn of something you may not have heard of called the q ratio.

Before I get into explaining the q ratio, take a look at this chart from Advisor Perspectives. It shows q for the US stock market going back to the year 1900. The higher the q value, the more expensive the stock market.

Source: Advisor Perspectives
Source: Advisor Perspectives

What’s clear is that with q measuring 1.09 it has only ever been higher than the current level at one time. That was during the massive technology bubble in 2000, when q briefly touched 1.64 before the market collapsed.

These days q is around 20% higher than it was in 2007, before the last market downturn and eventual crash. And it’s just above the 1.06 level reached in 1929, immediately before the notorious Wall Street Crash.

In fact the current q ratio is 60% above its average (mean) level of 0.63 over the past 115 years. So the US stock market would have to fall in price by 38% just to reach the average level. Crashes often undershoot the average.

Historical lows for q in the 1920’s, 30’s, 50’s and 80’s were around a level of 0.30. For today’s market to reach that kind of level would mean plunging 72% from today’s prices.

More recently, after the market collapse that occurred between October 2007 and March 2009, when the S&P 500 fell by 57%, q bottomed out at 0.57. That’s 48% below the current reading.

In the past, peaks of the q ratio have signalled the worst times to buy US stocks. Troughs, such as 1982, have coincided with the start of major bull markets.

So what is this mysterious “q”? How is it calculated? And why should we pay attention to it?

Put simply, the q ratio is a comparison of the value of companies in the stock market, or their market capitalisation, with the replacement cost of their net assets, or equity (assets less liabilities).

It’s similar to the price-to-book ratio (P/B), which compares the market capitalisation with the accounting value of net assets, known as the book value. But book value tends to be lower than replacement cost, meaning P/B is usually higher than q.

This is because accounting rules mean that many assets are valued in company accounts at the historical cost when they were bought, less accumulated depreciation charges.

In other words, it would usually cost more to replace the assets owned by a company than the value reported in its accounts. A simple example would be a building or piece of land bought many years ago. In most cases it would be worth much more today than the original purchase price, less any accumulated accounting depreciation.

We can see this difference between P/B and q by looking at the current price-to-book ratio of the S&P 500, which is 2.92. That’s 2.7 times as large as the q ratio of 1.09.

Although the figures are different the basic idea of q is similar to P/B. It’s a comparison of stock market value to a measure of net assets. Comparing q to P/B doesn’t tell us much. But by looking at a time series of each ratio on its own we can see how it compares to historical levels. And q is clearly at a high level, indicating rich prices in the stock market.

(Note: I’m talking about  what Andrew Smithers, of Smithers & Co., refers to as the “equity q”. It’s similar but not the same as “Tobin’s q”, a concept developed by Nobel Laureate James Tobin. Tobin’s q also includes the market value of liabilities in the equation, but it’s best to exclude them for stock market analysis purposes.)

Q is usually hard to calculate because it’s difficult to estimate the replacement cost of company assets. But fortunately, for the aggregate US stock market at least, the work is done for us. The Federal Reserve provides the necessary raw data each month.

The long and the short of it is that q is telling us the same story as another useful figure, the P/E10 ratio. The P/E10 ratio is also known as the Cyclically Adjusted Price-to-Earnings ratio (CAPE) or Shiller P/E. See “Seven Years of Famine in US Stocks” for more about the P/E10 and its extremely high level.

There’s a chart on the Smithers & Co. website that compares both q and P/E10 (CAPE) to their own averages since 1900. Both ratios clearly show extended levels of overvaluation, with q at a level 75% above its historical average and P/E10 (CAPE) 89% above average.

(To find the chart click here, then choose menu option “q and FAQs” and then sub-menu option “US CAPE and q chart”. I can’t reproduce the chart here or even give a direct link to it because Smithers & Co. doesn’t permit that, for reasons best known to themselves. Here at OfWealth we prefer to take the approach that anything provided for free is freely provided.)

It’s not just the q ratio or the P/E10 that signal that US stocks are expensive. My article “Why I am buying Russia and selling the USA”, looks at P/E, P/B, dividend yield and P/E10 in a range of country stock markets.

Only the US is expensive on all four of those measures. With q on board, now we can add a fifth measure that also points at indicates that US stocks are poor value at current prices.

All valuation ratios have pros and cons. Market cheerleaders can always attempt to pick holes in them if they give the “wrong” answer. But when all measures are saying much the same thing we would be foolish to ignore their message.

One day US stocks will be attractive investments again. But for now every meaningful valuation measure is saying “stay away, the market is expensive”.

If you have a large allocation to US stocks then I recommend you reduce it sharply, or sell it completely. You don’t want to get stuck in the queue for the exits if and when prices collapse.

People often forget that market crashes can take time to build up. US stocks have been trading sideways this year. They did much the same during 2007, the last period of high prices. Then the slide started to accelerate in 2008, culminating in the late 2008 / early 2009 crash (see the following chart of the S&P 500 during that period).

Source: Google Finance
Source: Google Finance

Many seem to think the global financial crisis suddenly happened in late 2008. It didn’t. It started in early 2007, when the first banks started to report multi-billion dollar losses from sub-prime mortgage lending in the USA. But the full market panic didn’t happen until late 2008. However, the smartest investors were long gone from the stock market by then.

We may or may not get a crisis or crash of that magnitude this time around. But with already falling US corporate revenues and profits, and the prospect of interest rates starting to rise later in the year, the omens are not good for ongoing strength in the US stock market.

The good news is that are more attractive alternatives. Recently OfWealth has highlighted opportunities in stock markets such as Colombia, Russia, Norway, and China. And if you don’t like the look of any of those then I suggest a mix of cash and gold until US stocks offer (much) better value.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.