First, if you're not familiar with Tobin's Q, Investopedia explains it as, "A ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets."
"For example, a low Q (between 0 and 1) means that the cost to replace a firm's assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm's stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued. This measure of stock valuation is the driving factor behind investment decisions in Tobin's model."
Don't worry if you're not grasping technicalities of Tobin's Q. What I want to convey is that Tobin's Q is a nice valuation metric and, when graphed over time, it moves in a very established channel. Jill Mislinksi from Advisor Perspectives issued a nice research piece the other day that really dove into Tobin's Q and market valuations. I'm borrowing the following chart from that article:
Now let's take the analysis a little further. Let's assume we are indeed at a market top and we're poised to correct. What kind of downside are we looking at? Well if you look back at the hundred years between 1900 and 2000, just about every market top (1.0-1.1) was immediately followed by a drop to the lower bound of 0.30 - almost without exception. That trend changed, however, in the early 2000s. Notice how the Q Ratio was not allowed to correct to its 100 year natural low. Through the Fed's use of magic monetary policy, the ratio only made it back to the 100 year average of 0.70 before re-inflating during the housing bubble. Do you remember the Great Recession once housing went bust? Even then, Tobin's Q only correct to 0.57, well above the lows of previous cycles going back over 100 years. My point here is that policy makers have not allowed the market to adequately purge the excesses of back-to-back stock market bubbles. That is a bad, bad thing. Today, we not only have the excesses still in the system from the dotcom and housing bubbles, but now we have the excesses that have built up from worldwide ZIRP (zero interest rate policy) and QE.
So what happens if/when Tobin's Q is actually allowed to correct back to historical lows? For that we look at the long term chart of the S&P 500.
Now take a look at the exact same chart, but this time with the addition of a simple trend line.
Understanding that these are just two methods of many by which to analyze the market, I found it interesting that they both point to precisely the same level. I'll leave it up to you to decide if they're relevant or not.