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Tobin's q

 
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arthur
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PostPosted: Tue Jan 25, 2005 8:13 pm    Post subject: Tobin's q Reply with quote

James Tobin is a Keynesian Economist, who created an interesting stock market valuation method.

Contrarian Views.
Stephen A. Hendricks.
Beleggers Belangen. , 24th December 2004

Stephen Hendricks: It seems like the recovery of the US economy is well underway, the S&P500-index has gained about 8% this year. So there’s every reason to be positive on the stock market for the in the medium term, don’t you think?

Andrew Smithers: Not really. We were very lucky that the 2001 US recession was so mild. This was largely the result of a well timed tax cut, but the timing was sheer luck. It happened at the right time because it happened for the wrong reasons. The Republicans didn’t cut taxes because they saw the recession looming, but because they didn’t want the Democrats to have a go at spending the budget surplus. As such good fortune is unlikely again, the next recession is likely to be much more severe and the recovery will be more difficult, as there is less room for further tax cuts.

Stephen Hendricks: In how bad a shape is the US economy?

Andrew Smithers: Partly because the 2001 recession was mild, the structural problems that built up in the bubble have not been resolved. In particular the excess debts are still there, but the US is in denial, like people always are when dealing with serious problems.

Stephen Hendricks: Is there any solution for the debt problem?

Andrew Smithers: Basically there are three possible solutions. The first is widespread default. This leads to recession, as the defaulters are unable to obtain credit and cut back on their consumption and investment. Those who have suffered capital losses do likewise. The second possibility is to swap equity for debt. This also tends to cause recessions, as the new supply of equity depresses the stock market and causes investment to fall, as the cost of capital rises, and consumption to fall as the decline in wealth pushes up household savings. The third route is to allow inflation to erode the debt level, but I don’t think the Fed is yet ready for this, though they may become willing to accept inflation in the next recession.

Stephen Hendricks: Still, in spite of these problems, optimism seems to rule the stock market. Why?

Andrew Smithers: It usually takes three hard lessons for people to change their behaviour. This one stock market correction didn’t do the job. Besides, people are simply not rational and seem to believe that stock prices follow a random walk. They think the stock market has no memory. The evidence is against this. Stock returns show negative serial correlation, that is to say, a sustained period of years with above average returns will be followed by a period with poor ones. The US stock market has given annual returns of around 9% over the last 10 to 30 years, compared with the 100 year average of around 6%, so it’s only logical to expect returns well below 6% for the medium year. This is just the bad news that comes from the mean reversion of value - it offsets the usual good news which comes from the same feature.

Stephen Hendricks: Why is this?

Andrew Smithers: If stock prices followed a random walk, (i.e. if values were not mean reverting) they would be much more volatile and therefore stocks would be a more risky investment than they actually are. But since stock values are mean reverting, we know that when they are high, as they are today, we must expect future returns to be bad and for the stock market to go lower.

Stephen Hendricks: How much lower?

Andrew Smithers: If you compute a fair value on the basis of Tobin’s q, the US stock market is around 50% overvalued. If the market is at fair value in say 5 years time, this implies a real return over the next 5 years of around -2% p.a.

Stephen Hendricks: Why are stocks values mean reverting?

Andrew Smithers: Competition normally drives down the prices of goods and services to their cost of production. If goods can be sold for more than it costs to produce them, production is expanded, competition comes in and prices move downwards. It’s no different with companies. If the value of a company is higher than the cost to create this company (also known as replacement value) than there will be tendency for existing companies to invest more and for new companies to be started. This will have the effect of driving down the value of companies. This process means that the market value of equities moves around their net worth (at replacement cost). The extent to which the market value differs from replacement cost is what q measures. On this basis there is a current overvaluation of 50%.

Stephen Hendricks: That’s a dim view. What could trigger a stock market decline in your view?

Andrew Smithers: That’s a difficult question. This time it could be the quoted companies themselves that start the process. In the US a lot of companies are currently buying back their own stock, recently more than 100% of the profits of non-financial companies have been used to pay-dividends or buy-back shares. This can’t go on indefinitely as leverage would get worse and worse. US companies are almost the only class of investors who are net buyers of shares. If they slow down, share prices are likely to fall.
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