Saturday, December 6, 2008

Bill Gross on the Q Ratio


For commenter Dr. Paul Price, aka Stockdoxc, who prefers to see the glass as half-full, above is the Q Ratio chart from Bill Gross's December Investment Outlook, and below is Gross's explanation of the metric.

I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.

One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.

7 comments:

Alan Greenspan said...

With all the printing of money going on I think it's a given we'll see much higher inflation in the coming years.

The current fear of deflation is temporary and overblown.

Ownings bonds with more than a one year maturity could end up being the worst investment error you could make.

You need to own something that can be marked up when inflation kicks in. Real estate, commodities [from today's levels, and stocks at current bargain prices have the capacity to do that.

10-year treasuries at 3% look like a sure loser of major proportions.

Paul Volker said...

Not only are stocks historically cheap as shown in the Q chart, but they now compete with record low fixed interest rate bonds and CDs as opposed to the early 1980's when banks offered double digit rates to savers.

That makes the undervaluation of equity look even more compelling than it did then.

DaveinHackensack said...

I agree about 10-year Treasuries looking like losers. Gross said corporate bonds, not Treasuries, looked attractive though.

"Not only are stocks historically cheap as shown in the Q chart, but they now compete with record low fixed interest rate bonds and CDs as opposed to the early 1980's when banks offered double digit rates to savers."

Stock market history didn't start in the early 1980s though. At the end of the secular bear market that started during the Great Depression, stocks had lower valuations (S&P had an average P/E of 7x trailing earnings) despite the low interest rate environment. In fact, stock dividend yields were higher, on average, than corporate bond yields or Treasuries.

B Obama said...

Are you expecting another great depression now?

DaveinHackensack said...

No, but I think we are in another secular bear market for stocks, one that started in 2000.

Michelle Obama (the real prez) said...

Barack is too shy to ask because he doesn;t know what a secular bear market is.

If we're in on how would that affect your stock picking now?

DaveinHackensack said...

Michelle,

Your assets will be managed in a blind trust while you and your husband are in the White House, so no need to trouble yourself with the details of investing. For the rest of us though, the recognition that we are in a secular bear market means that we need to have more conservative and realistic expectations about the earnings multiples the market will grant stocks over the next decade or so. For example, if a former high-flyer traded at a double digit multiple a few years ago, it may be unrealistic to expect it to return to such lofty multiples. Remember, when the last secular bear market ended, stocks traded at an average of about 9x trailing earnings, and when the one before that ended, they traded at about 7x trailing earnings.