Under the Hood: Stock Market Valuation, Pt. 2

In my previous article on valuing the U.S. stock market, we looked at Warren Buffett's favorite valuation measure, total market cap to GDP. We learned that, according to this ratio, stocks are indeed overvalued today. We also learned that stocks could continue to be overvalued for an extended period of time before a correction materializes. In short, there are a number of good methods to measure the market's current valuation. However, because investors are not rational, a correction can occur at any point, even when valuation ratios are close to fair value.

In this article, we'll look at two additional market valuation tools, Tobin's Q Ratio and Robert Shiller's C.A.P.E. Ratio. Like Buffett's favorite, these paint a similar picture of the current stock market. Even so, when used in conjunction, they can provide great insight into an issue that is on the mind of many investors: where does the market go from here?

Valuation Measure: Tobin's Q Ratio

Tobin's Q Ratio was developed by James Tobin, recipient of the 1981 Nobel Prize in Economic Sciences. Tobin earned his first post-secondary degree in 1939, his M.A. in 1940, and his Ph.D. in 1947, all from Harvard University. His brilliance influenced many in the field of economics, and one of his most lauded contributions is his Q Ratio which compares an asset's market value to its replacement value. The numerator contains the asset's fair market value and the denominator is the asset's replacement value. Here it is expressed as an equation:

Tobin's Q Ratio = Fair Market Value / Replacement Value

Although it's not an exact match, it has become common to calculate the ratio as follows:

(Equity Market Value + Liabilities Market Value) / (Equity Book Value + Liabilities Book Value)

To interpret the ratio, if a company's market value is equal to its book value, it would be considered fairly valued. If a company's market value is greater than its book value, it would be considered overvalued. The following chart contains the ratio from the fourth quarter 1949 through the third quarter 2014. The data is derived from the Federal Reserve report: Z.1 Flow of Funds Accounts of the United States. It is found in Table B.102, lines 35 and 32.

As you can see, the ratio was in extreme territory during the tech bubble, reaching a record high of 1.775. For a little perspective, its long-term average is 0.743. Leading up to the housing bubble, it was actually under 1.0, indicating stocks were slightly undervalued. Today, it's in mildly over-valued territory, but nothing which would be considered alarming. Considering that it was low when the housing bubble burst and stocks plummeted, one must wonder about the efficacy of this particular ratio. Let's move on to the next valuation measure.

Valuation Ratio: Shiller's C.A.P.E. Ratio

Developed by Robert Shiller, Nobel Laureate in 2013, this ratio incorporates an approach argued for by famed value investors Benjamin Graham and David Dodd. Decades later, Shiller co-authored a paper in 1988 with economist John Campbell concluding that "a long moving average of real earnings helps to forecast future real dividends." Since a stock's intrinsic value is based on the present value of its future income stream, Shiller and Campbell discovered that, by using a long-term period of five or 10 years and adjusting for inflation, they could more accurately determine the real value of an individual stock or a broad index.

This was the genesis for the Cyclically Adjusted Price-Earnings ratio (C.A.P.E), also known as the Shiller P/E or P/E 10 ratio. The authors also found a relationship between this ratio and forecasting future returns. In short, they learned that a lower ratio led to greater future returns during the following 20-year period. However, we'll confine our discussion to its value in determining if a market is over- or under-valued.

The following graph contains the C.A.P.E. ratio from January 1, 1900 through February 15, 2015. Recessions are shaded in gray.

Note that in September 1929, just prior to Black Monday, the ratio hit 32.56. In December 1999, just before the tech bubble burst, it hit 44.20, its highest point on record. In June 2007, just before the housing bubble burst, it was at 27.41. Today it stands at 27.49. Its long-term average is 16.59. Therefore, today's level indicates that stocks are indeed overvalued. However, as we have seen numerous times with this and other ratios, even though the market may be overvalued, a correction may not occur for several months.

Putting It All Together

To summarize, let's assume these ratios are accurate and today's stock market is overvalued. Because humans are making the investment decisions (for the most part anyway), since we are emotional creatures willing to ride the profit train longer than we should at times, a measure of caution is in order.

In short, the markets may be overvalued and a correction may be imminent, but exactly how imminent is anyone's guess. I suggest using the various valuation measures together and becoming more cautious as they rise, indicating that stocks are becoming more overvalued. At some point, the rubber band will reach its limit and the correction will come. It's not a question of if, but when.

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Read the prior article in this series, Under the Hood: Stock Market Valuation, Pt. 1: Buffett's Choice

Under the Hood: Stock Market Valuation, Pt. 2—Shiller and Tobin

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