Tobin’s Q explains the recent stock market rout

Global financial markets have been on the run since last Thursday, the trend is still downwards, as I write. The correction this time started from the East and moved to the West till about $5 Trillion got corrected downwards globally in financial asset valuations, entirely in equities.

When the valuations are on the rise, the typical reasoning we give to the emphatic rise is different from what we surmise when the valuations fall. When the fall is sharp, as in the current case, the reasoning could be as far wide, deep and lost in arguments on both sides of the pole as can be.

For example the rise in S&P 500 to the unprecedented levels (Tobin’s Q at 1.1) we have never seen did not bring in the related discussion on inter-connectedness of the global financial system, or the fortunes of emerging markets being linked to the global community. The discussion revolved around the individual stars sparkling in the group. This is all the more so, as stocks do not sharply rise in reverse panic, so the going is gradual with many peaks to be scaled and many winners in the making.

The typical discussion, when the stocks fall sharply, moves to the external factors to start with, from China to Federal Reserve, there is an all-round effort to find reason in the madness. Krugman had the most bizarre explanation on NY Times on 24th August in the middle of the rampage, “A Moveable Glut”, where he practically goes back to Bernanke’s Savings Glut hypothesis. Lawrence Summers makes a different point blaming Fed on the same day in his article on FT “The Fed looks set to make a dangerous mistake”.

Trying to explain such a complex event as a stock rout is never easy in the first place, but one could attempt to understand what happens when valuations make a change in trajectory; it could be worthwhile to use some simple tools like the Tobin’s Q to understand these gyrations. But as market participants are risk averse to making losses far more than making gains, it is only more likely that their resolve to take a shield against a looming loss would be far more sharp and decisive.

One cannot also rule out the prospects of a rising tendency for “short” punters, who become active even before the market opens and the sale orders take the initiative in futures as well. But that is a given normal, not the true driver for a sudden change in trajectory of the market, that too globally. These are natural speculators who end up on both sides of the bargain in such times.

The analysis reveals that Tobin’s Q, which measures the ratio of the market value of installed capital to  the Replacement Value (which could be simplified to Market value of Assets to Book value of assets) , when crosses a threshold, the market has stuffed too much in the hope of the stock doing better into the future, while the circumstances in the current scheme of things do not seem to suggest such an event from happening, or raises the doubt that such expectation of future stream of cash flows could be questionable. Such a doubt when it confronts a reality in an inter-connected market, as in this case China, threatens a contagion or a cascade, when hordes of investors feel in unison that a change in expectations is imminent, the Tobin’s Q is set for a sharper correction.

Those who want to read further, could read in my Blog: https://procyonmukherjee.in/article/55

 Or else continue reading........

Tobin’s Q

If we were to sell all assets (tangible and intangible) of a company or a group of companies then we would have arrived at the numerator of the Tobin’s Q, while its denominator would be the net worth of the firm.

If for the moment we simplify Tobin’s Q to reflect the degree to which the market value of equity exceeds its book value through a ratio, then its absolute value could either be greater, lesser or equal to 1.

Tobin’s Q > 1, this would mean that the present value of the future earnings exceeds its cost, thus it would make more sense to buy such a stock or for the company to invest in new capital. But too much buying would raise this ratio to such a level that the intrinsic value of the firm would be lost in the ‘halo’ effects (the stock becomes over-valued) and that is when the buying would stop to bring parity. On the other hand if the firm raises its capital investment too much, the marginal product of capital would diminish beyond a point, thus restoring parity at the end.

If we divert our attention to a single firm, which is embarking to make investment in green field projects, it starts off with a higher Q but moves to lower Q as the projects have a gestation period before the actual installation starts to bear fruit. The greater the scale of the investment project, the greater the demands on managerial resources and the greater the disruption to existing operations of the business. In general, the bigger the volume of investment undertaken in a given time period, the more costly it will be to install it. Thus, perhaps fortunately, firms will take time to move from their current capital stock, M1 to the desired capital stock, M2 suggested by the Q ratio.

If Q<1, in a steady state, it could mean that the present strategy is not able to fully realize the potential of the firm’s intrinsic value and the stock therefore is under-valued. It could also be that the factor costs or other imponderables play a role to dampen the prospects of the firm such that the market value of invested capital is lower than the cost of invested capital. Such a firm cannot venture to invest unless it is able to remove the infirmities it is inflicted with. It also means that if the firm where to be sold off, the proceeds would not cover the investments made in the firm.

S&P 500: Tobin’s Q

 When the S&P 500 got to the level such that the Tobin’s Q became 1.1 in June 2015, there were some murmurings that the market is starting to get over-heated as it is only 12% of the entire period of time (between 1900 to 2015) that the ratio exceeded 1.

If one looks at what the corporate America did in the entire period from 2011 to 2015, it did not make major investments while the Q Ratio was increasing from 0.7; it used the surplus cash to buy-back stocks instead. This was a really clever move to not get locked in the marginal product of capital.

The P/E ratio moved up as the number of outstanding stocks came down and it allowed the price to move up.

Thus we see the Tobin’s Q to scale up steadily to 1.1

However at 1.1 it becomes apparent that over-valuation of the invested capital raises the doubt that future earnings could be insufficient to service the cost behind such earnings.

The market was waiting for cues, and the most dominant one was to take one from the emerging market, which was already into a far higher territory. Data is not available, but I assume that Shanghai’s Stock exchange for the top 1000 companies were hovering around more than 1.2 (Tobin’s Q), which brought them to a sharp correction which was on the cards.

Investment Cycle & Business Cycle

 What has actually happened in the current period between 2009 to 2015, is that the investment cycle peaked to the point that it was pushing the Q from a higher to a lower ratio, but artificially the market counter-acted to keep the ratio unchanged. The role of interest rate was critical in this as it helped to push investments on one hand and it also allowed artificial movement of prices as share-buybacks became far too economical at low interest rates.

The business cycle also was reaching the next peak (this was a really short cycle) and there is enough visible signal in the commodity prices.

The announcement of the interest rate change coincided with the situation.

The market had to finally be where it had to be.

Procyon, 25th August 2015