This is a public service announcement on Tobin’s q. Following my On Monday column, there were several requests for charts. Here, then, is a chart produced by Andrew Smithers showing how Tobin’s q and the Robert Shiller cyclically adjusted price/earnings ratio vary with respect to their own mean over time:
As is evident, these two measures send remarkably similar signals, and could even be held to support each other. There is far more detail about these measures in other posts on this blog, and also in today’s Analysis piece on Jeremy Siegel’s criticisms of Cape.
For now, briefly, the argument of those who take these measures seriously is that one (q) is an economic concept to do with the replacement cost of a company’s assets, while the other (Cape) is a financial concept related to the flow of earnings that a company produces. They come from different directions and yet they give very similar results – and over history extreme measures for both have been great indicators that it might be time to enter or exit the market. That is why people think they work.
The criticism of Cape, broadly speaking, is that changes in accounting and taxation make it impossible to compare contemporary earnings with earnings made before the second world war, and so the long-term average is misleadingly low. Meanwhile, the criticism of q is that it fails to account adequately for the growth in importance of intangible assets.