March 16, 2009 - The Manual of Ideas

EQUITIES AND TOBIN’S Q

Edited by the Research Team of

“The miserable failures of capitalist economies in the Great Depression were root causes of worldwide social and political disasters.” —James Tobin

With

John Mihaljevic, CFA Managing Editor,

The Manual of Ideas [email protected]

About This Report Equities and Tobin’s Q, 1900-2009 —Evaluating the Market Outlook in the Context of a Century of History Report Date: March 16, 2009 Publishing Frequency: Quarterly Website: www.manualofideas.com/q

Inside This Report Quarterly Update ……………… p. 1 Today’s Q: Bullish or Bearish? … p. 2 Economic Rationale …………… p. 3 Q in Investment Management … p. 6 Putting Q in Historical Context … p. 7 Q and Warren Buffett ………… p. 8 Calculating Tobin’s Q ………… p. 9 Selected Charts and Data ……… p. 11 Additional Resources ………… p. 19

About The Author John Mihaljevic served as James Tobin’s research assistant from 1996-98 and worked with Professor Tobin to refine the Q estimation method. Mr. Mihaljevic was also involved in various research projects at the Cowles Foundation, including researching and editing James Tobin’s Money, Credit and Capital. Mr. Mihaljevic, CFA, graduated summa cum laude from Yale, having earned distinction in the study of economics. In addition to working for and studying under James Tobin, Mr. Mihaljevic also studied under Yale Chief Investment Officer David Swensen and Sterling Professor of Economics William Nordhaus. Mr. Mihaljevic has worked as an investment banker, equity research analyst and investment manager. He currently serves as managing member of Mihaljevic Capital Management LLC and managing editor of The Manual of Ideas.

Dear Subscriber, h We estimate Tobin’s Q at 0.43, well below parity and well below an adjusted average of 0.76 for the period 1900-2008. Our data shows that Q declined sharply in 2008 and again YTD, down from 0.89 at yearend 2007 to 0.55 at yearend 2008 and to 0.43 as of March 15, 2009. The numerator (market value) and denominator (replacement cost) of the Q ratio were down 49% and up 5%, respectively, from yearend 2007 through March 15, 2009. h No evidence of deflation can be observed in replacement cost, with the denominator of the Q ratio rising 5% in 2008, in line with the increase recorded in 2007. Replacement cost increased 0.3% sequentially in 4Q08, reflecting a slower pace than for the full year but notably no decrease. Absent major deflationary pressure on replacement cost, we expect Q to return to parity through an increase in the numerator, i.e., a rise in the market value of equities and other assets. How long this process may take is obviously a crucial question but also one that cannot be answered reliably. h Despite the low value of today’s Q ratio, it sends only a modestly bullish signal for investors. Of the six other instances since 1900 when Q fell to 0.43 or below, it was higher one year later in three instances. Four out of six times, it was higher three years after the drop. Ten years after the drop, it was higher in all but one instance. h We cannot overemphasize the possibility of Q reaching extreme levels. The ratio hit a low of 0.29 twice over the course of the past century—in 1948 and 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949. h Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.43 is highly bullish if Q is on the upswing, but when the ratio is on the downswing, a value of 0.43 is only modestly bullish. h Those who argue that today’s Q sends an extremely bearish signal appear to be making three cognitive errors: − Undue focus on historical lows. While the low of 0.29 is materially below today’s Q, attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns. − Ignorance of the fact that the relationship between Q and stock prices is not quite linear. We estimate that a 50% drop in Q from current levels would be accompanied by a one-third drop in stock market indices. − Ignorance of the fact that replacement cost, the denominator of the Q ratio, has increased each year since 1946. Sincerely,

EQUITIES AND TOBIN’S Q is published quarterly by BeyondProxy LLC, P.O. Box 1375, New York, NY 10150. Website: www.manualofideas.com. Email: [email protected]. Please email or call if you have any subscription questions. Managing Editor: John Mihaljevic. Subscription $399 per year. © Copyright 2008 by BeyondProxy LLC. All rights reserved. Photocopying, reproduction, quotation, or redistribution of any kind is strictly prohibited without written permission from the publisher. This report bases recommendations and forecasts on techniques and sources believed to be reliable in the past and cannot guarantee future accuracy and results. BeyondProxy’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this report. John Mihaljevic, Chairman of BeyondProxy, is also a principal of Mihaljevic Capital Management LLC (“MCM”), which serves as the general partner of a private investment partnership. MCM may purchase or sell securities and financial instruments discussed in this report on behalf of the investment partnership or other accounts it manages. It is the policy of MCM and all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities or financial instruments discussed herein are made. Use of this report and its content is governed by the Terms of Use described in detail at www.manualofideas.com/terms.html.

EQUITIES AND TOBIN’S Q — March 2009 THE DEBATE Is Today’s Q Giving a Bullish or Bearish Signal for Equities?

Tobin’s Q Ratio, 2000–2009 1,2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Source: The Federal Reserve; Blanchard, Rhee, and Summers; The Manual of Ideas.

Disagreement between leading investment managers and strategists has been remarkable. Consider the diametrically opposed views of two prominent figures: h Bill Gross, the outspoken Managing Director of PIMCO, a leading global investment firm with more than $790 billion in assets under management, asserts that the “Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation...” Access Bill Gross’s full December 2008 Investment Outlook: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+Dow+5000+Gross+Dec+08.htm

h Russell Napier, Strategist at CLSA, a leading international brokerage and investment group, claims that the Q ratio supports his expectation of a “horrific” market bottom and another 55% drop in the S&P 500 Index by 2014. Access the full article: http://www.bloomberg.com/apps/news?pid=20601087&sid=a6iiap2DL_gQ

Based on our proprietary analysis and the data presented in this report, we conclude that today’s estimated Tobin’s Q ratio of 0.43 sends a modestly bullish signal for equity investors. We note that Q had fallen to 0.33 in early March, hovering near 20th-century lows. At 0.33, Q was in strongly bullish territory. The stock market rally during the second week of March was unsurprising in the context of Tobin’s Q.

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As of March 15, 2009. This chart consists of two data sets: (1) 1900-1944: We use a modified Blanchard, Rhee, Summers data series. We adjust data in the series downward to reflect the series’ upward bias as compared to the Tobin (new) methodology developed by James Tobin and John Mihaljevic. (2) 1945-2008: We use the Tobin (new) data series, updated through December 16, 2008. We believe this combined set of data from 1900-2008 provides the most accurately historical rendering of the Q ratio.

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Publisher: BeyondProxy LLC

Edited by the Research Team of The Manual of Ideas

www.manualofideas.com/q

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EQUITIES AND TOBIN’S Q — March 2009 BACKGROUND Tobin’s Q — Economic Rationale Tobin conceptualized the Q ratio as a measure of over- or undervaluation of publicly traded assets. In its simplest form, Q equals market value divided by replacement cost. h If the market value of an asset exceeds the cost of replacing it (Q>1), an incentive exists to recreate the asset and immediately sell it in the market at a premium to cost. As a result, incremental real investment will tend to force high Q ratios back down to parity (QÈ1). h No straightforward balancing mechanism exists in the case of low Q ratios, i.e., when the market is valuing an asset below its replacement cost (Q