By Michael Baxter 3 Aug 2010 [0 Comments | 1,342 views]
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Capital Economics released an interesting report yesterday, asking the simple question: is the UK stock market overvalued? To answer this question they took two pieces of data: first they compared company valuations as defined by the markets, with net worth as defined by the accountants. Secondly they looked at the cyclically adjusted price earnings ratio, which compares stock market valuation with profits.
The FTSE 100 rose 12 per cent last month. It’s 5 per cent down from the year high set in March, and down a tiny 0.3 per cent from the last day of 2009. It seems all the market shenanigans seen earlier in the summer and spring meant nothing. The old adage, “Sell in May and go away”, was proven correct. Why do we actually bother to look at daily changes on the stock market? It is rare indeed that a major sell off, or a big rise, is not reversed a few weeks later.
Of course, one might argue the markets have become overly complacent, even behaving naively. Their reaction to the Greek crisis, which has not gone away but is merely quietened for a few months while the EU bailout package papers over some very nasty gaps; and the banking stress tests that were little more than shambolic; does leave one shaking one’s head.
But let’s ignore the economics; what do the numbers say?
Well, what could be better than to start with a big fat letter Q.
In this case, Q relates to a measure defined by James Tobin, the American economist who came up with the idea of a tax on foreign exchange transactions. In one of those remarkable coincidences the tax is also known as a Tobin, or Tobin tax. You may recall, earlier this year and in 2009 there was much talk of introducing a kind of global Tobin tax. Anyway, Tobin also came up with a cunning way of testing whether stock markets, or indeed individual companies, were overvalued, and the measure is known as the Q test.
It works like this: add up the cost of replacing a company’s tangible and intangible assets, and divide this number into the market capitalisation of the company. If the result of the sum is greater than 1, then the stock is overvalued.
Thanks to the recent publication of the Blue Book by the Office for National Statistics, we now have a figure for the combined net worth of the UK’s non-financial corporate sector: it comes out at £1,510bn, using the same formula as used by the Fed for calculating the net worth of US corporates, or so says Capital Economics.
At the end of 2009, the stock market valuation of the same companies was £1,873bn.
In other words, equity Q quotient for non-financial UK companies is 1.24. Suggesting they are overvalued, and need to fall by just under 20 per cent.
But Q hardly ever is at the level James Tobin said it should be. The average since 1988 has been 1.15. So, it appears that by historical standards stocks are overvalued, but not by much.
We would like to suggest that you now help yourself to a pinch of salt. Just because equities have had a Tobin value greater than 1 for the last 25 years, it does not mean they always will. It is possible that markets have been consistently too exuberant for decades. See: Is the cult of equities dead?
But there is another way of looking at things. Instead, compare company profits with stock market valuation; or in other words look at p/e ratios, and in particular the cyclically adjusted p/e ratio which is calculated by taking average earnings over the prior decade and adjusting them for inflation, and comparing with stock market valuations. This, apparently, is the calculation preferred by Robert Shiller – he of the Case-Shiller US house price index and one of those gurus other economists defer to.
This particular measure of the p/e ratio was around 14.5 at the end of Q2, calculates Capital Economics. The average since 1988 was 18.4. Since 1975, the ratio was 15.8.
Put it all together and what do you get? A historical comparison of the Q ratio suggests stocks are slightly overvalued, but the historical p/e ratio suggests they should rise slightly from current levels.
Our own view is that markets are being overly optimistic, and are not taking into account the very real danger that a eurozone debt crisis as serious as the US subprime crisis proved to be, could yet erupt. In the long run, James Tobin’s view that the Q ratio should be 1, may well prove to be right.
We will take another look at the question of this Q ratio later this week, but from a slightly different, and a tad more optimistic perspective.
