Why The Market Isn’t Over-Valued: Tobin’s Q, Margins, Taxes

Why The Market Isn't Over-Valued: Tobin's Q, Margins, Taxes

Dear Investors,

A lot of my clients are worried about a potential stock market crash. The higher the market goes, the more they worry and the more questions they ask on the subject.

I understand why they worry. Human beings see patterns in everything. Several fascinating studies have been done on the subject.

In one study, researchers had a machine flash either a red light or a green light. Human subjects were asked to guess which light would turn on and got a reward if they were correct. The lights were random, with green appearing four out of five times and red appearing one out of five times. The test was performed on both humans and animals. Rats and pigeons did very well. After some random guessing, the animals continually picked green. Humans, however, habitually tried to find a pattern in the randomness and kept guessing red at various times. Even when researchers told the subjects the low probability of red appearing and that the lights were random, the humans persisted in guessing red.

Maybe the humans in that study were just dumb.

Another group of researchers conducted an experiment that pitted rats against Yale students. Food was put at either the left or the right end of a T shaped maze. The placement of the food was random, with food appearing on the left 60% of the time. The rats eventually figured out food appeared on the left more and always went left for a 60% success rate. When the Yale students were asked to guess where the food was more likely to appear, they only had a 52% success rate. They couldn’t get over the urge to try to see patterns and make guesses.

So what “patterns” have appeared in the stock market over the last decade and a half? The market goes up due to a bubble and then crashes back down. It has happened twice. This, to most people, is a pattern. We become conditioned to expect a rapidly rising market and then an inevitable crash. The takeaway is that to successfully invest, you need to time the market. Ride the wave up and then bail before it’s too late.

That’s why many clients are asking, in essence,  “Is now the time to bail?”

I don’t blame my clients (or anyone) for asking this question. It’s an important question.

A Two-Part Answer: Do You Own the Stock Market or Something Else?

I have a two-part answer for this question. First, I say, “You don’t own the stock market, so in the long run the only thing that matters is the performance of the small group of businesses you actually own.”

Many of my clients have had funds invested with previous financial advisors, usually a broker at a big wire house. Their previous portfolios usually contained a raft of mutual funds—a dozen different equity mutual funds was not uncommon. These portfolios typically performed almost exactly like the stock market, mostly because when taken together the funds probably owned most of the stocks in the stock market.

There are about 3,000 to 3,500 domestic stocks that are reasonably big enough that you might consider investing in them, with only about 1,000 being well followed by other investors and large enough for big institutional investors to buy.

Want to see the number of stock holdings in several of the world’s largest mutual funds? The Fidelity Contrafund has 325 holdings, the American Funds Growth Fund of America has 282 holdings, the Dodge and Cox Stock Fund has 145 holdings, and the American Funds Capital World Growth and Income Fund has 271 stock holdings.

There is invariably some overlap between the holdings, but advisors usually fill a portfolio with all different types of funds. There is a growth fund, a value fund, maybe a dividend fund, and usually at least one variation of my personal favorite, a “Strategic Opportunities” fund (the implication being the other funds that the mutual fund company offers have the non-strategic stocks?)

It wouldn’t surprise me if my client’s previous portfolios had 500 or even 1,000 different underlying stocks in it.

When this is the case, it makes a lot of sense to worry about the market. You basically own the entire stock market, so wherever it goes for the long term, you are going too.

Okay, you say. That’s all fine and good but when the stock market goes down even my clients’ portfolios may go down too. Maybe not as far. For instance, our dividend stock portfolio has been 75% less volatile than the market since its inception. Even so, if you own stocks you can’t escape the stock market completely, so it’s probably important to actually answer the implied question: Is the stock market overvalued and a bubble?

A Two-Part Answer: Is The Stock Market Overvalued?

Is it overvalued? No, not really.

Let’s start with the argument that the stock market is a bubble and see what evidence there is in support of that.

Tobin’s Q
In the 1960s, Nobel laureate James Tobin came up with a measure of valuing the stock market. It looked at the ratio of the value of the stock market to the replacement cost of assets (similar to book value) of the companies. The median value is .7 and the current value is 1.02.

As you can see in the graph above, we are well past the danger zone (the red line) and in fact we have generally been past the danger zone since the mid-1990s.

The fact that we have been living in what, according to Tobin’s Q, is a bubble for twenty years should be a clue that something might not be quite right with this valuation methodology.

Tobin’s Q worked great for the 1950s through the 1970s when it was developed. During that time, most publicly traded companies were asset-heavy manufacturing, materials, railroad, or utilities companies.

Today, the market is made up largely of asset-light services, technology, software, and financial firms.

For those who are unfamiliar with what I’m talking about, allow me to explain “asset-heavy” and “asset-light.”

Suppose you run a widget manufacturing company. You need to buy a large building to use as a factory, you need to buy lots of machines to make the widgets, and you need to buy forklifts and other tools to move the widgets around. You need to keep a stock of raw materials like steel and rubber (I guess we are making steel and rubber widgets…) on hand. So your widget company has a lot of assets that are reflected in the financial statements on the balance sheet at something usually reasonably approximating what they are worth (subject to various accounting rules).

Now, suppose you run a software company. What assets do you need? A couple of computers for your employees, some desks, and some chairs, and some office space? Or maybe not even that. Employees can work from home. The main assets the company has will be the intellectual property rights to the software, which will not be recorded on the balance sheet at anywhere close to the actual value.

I did some research on the composition of the stock market in 1957 and today in 2013. I looked at what types of companies made up the S&P 500 (INDEXSP:.INX) stock index. I grouped each company into one of sixteen categories and classified each category as either asset-heavy, asset-average, or asset-light.

The asset-heavy categories included real estate firms, such as those that own land, office building, rental units, etc; utilities companies, such as those that own power plants and transmission lines; materials companies, such as mining companies and steel mills; manufacturing companies, such as an automaker; transportation companies, such as airlines or railroads; and oil and gas companies.

The asset-average categories included telecommunications companies, retailers, and consumer goods companies. (It generally takes less equipment to manufacture an Uncle Ben’s Rice Bowl or a pack of diapers then it does a car.)

In the asset-light category I included services companies, such as consulting firms; healthcare companies, which despite being technically manufacturers of healthcare products tend have more in common with asset-light firms because of high profit margins; pharmaceutical companies; technology companies; software; media; and financial companies.

Here are the numbers I came up with.

Category 1957 2013 Change (%)
Real Estate 1 14 1300%
Utilities 43 31 -28%
Materials 105 33 -69%
Manufacturing 143 73 -49%
Transportation 33 5 -85%
Oil & Gas 17 40 135%
Telecommunications 5 10 100%
Retail 35 45 29%
Consumer Goods 70 37 -47%
Services 6 40 567%
Healthcare 1 43 4200%
Pharmaceutical 10 11 10%
Technology 11 26 136%
Software 0 13 Nan
Media 12 10 -17%
Financial 8 69 763%
Total Asset Heavy 347 206 -41%
Total Asset Average 105 82 -22%
Total Asset Light 48 212 342%

I probably classified a few companies incorrectly, but the differences are large enough that any classification errors won’t matter.

The changes from 1957 until now are staggering. Asset-light firms grew by 342%, while asset-heavy firms like manufacturing and materials fell by almost half.

The type of economy, and thus the make-up of the companies in the stock market, has changed drastically since Tobin’s day and thus Tobin’s Q is a flawed measure of whether the stock market is expensive or not and in a bubble. For this reason, Tobin’s Q isn’t widely used except by the most ardent perma-bears. Since Tobin’s Q will almost always show a bubble, it works great to support their arguments.

Corporate Profit Margins

The next argument, and this is much more widely found than Tobin’s Q, is that corporate profit margins are at an all-time high and will inevitably fall. You can’t throw a virtual stick in the online investment universe without hitting a person or article touting this argument.

The graph below shows that this argument is indeed correct. Corporate profits as a portion of the economy are at an all-time high of about 11%.

The problem with this argument is not that it isn’t true. The problem is that it is extremely unhelpful. The argument is “corporate profit margins are at all time highs so eventually they will revert to the mean and therefore corporate profits will fall,” and, of course, falling profits mean a falling stock market.

Fine. But when will the fall? By how much will they fall? Over what time period will the fall take place? And what events will precipitate the decline in profit margins? The important parts of the argument are missing.

The bears need to fill in the following sentence:

Corporate profit margins will fall __________ because of ________.

Since all of my clients still have at least some of their assets in stocks, I’ll fill in my version of the sentence with my prediction.

Corporate profit margins will not fall during the remaining years of Obama’s presidential term because of high unemployment, low union participation rates, low corporate tax rates, high corporate welfare spending, and strong corporate political power.

Why Corporate Profit Margins Will Stay High
Here is why I think corporate profit margins will remain high.

Earlier, I showed how the economy has become more services oriented. For many of these “asset-light” firms, salary and compensation are one of the biggest expenses. If you can keep compensation down, then you can keep profits up. What better way to hold wages down than an enormous pool of 19M unemployed workers?

The graph below shows wages as a percent of GDP. Since the 1970s, wages have been steadily falling and remain at the lowest share of the economy since data collection began in the 1940s.

Why has this happened? Well, you don’t have to give employees a raise if they can’t find another job and if someone is waiting in the wings to replace them. The following graph shows the ratio of employment to population for the US.

The twin tech and financial bubbles took employment down from about 64.5% of the population to about 58.5%. That’s about 6% out of a total population of 314M, or 19M people that are willing and able to work but cannot find a job. It’s a human tragedy on an epic scale that Washington has ignored for years.

There are other factors at work as well that have kept wages down. Stagnating wages are the result of the decline of unions, a decade’s long government policy of not raising the minimum wage to keep up with inflation and of targeting something called NAIRU (Non-accelerating inflation rate of unemployment) rather than full employment (i.e., keeping a buffer of unemployment in the economy to keep price levels down). Have you been to the grocery store or looked at college tuition lately? That policy is working out great! But at this point in time, I believe the pool of 19M unemployed is the single biggest factor holding wages down.

Taxes Are Just for the Little People

Corporate profits may be at record levels, but, hey, at least they are paying taxes. Right? Nope.

Here is a chart of federal tax receipts for individual income taxes and corporate income taxes, which make up a bulk of federal tax receipts (social insurance programs are considered self-funded and excise and other taxes make up a very small portion of receipts).

During the 1930s through the early 1950s, individual income taxes and corporate income taxes averaged about an even amount, split roughly 50/50 if you averaged them out over that two decade time period.

Then, the corporate lobbyists got to work. We now have individuals contributing over 80%! of the federal tax burden while corporations are paying less than 20%. Keep in mind that large multinational corporations have received most of the tax breaks. Your average local small business pays a much higher tax rate than your average large corporation.

How is this possible? Well, it’s something you’ve probably heard a lot about. The welfare and entitlement state is out of control. The welfare queens and the 47% of American that are the “takers” are at fault.

And just where can you find these despicable people suckling at the taxpayer teat? The mean streets of Camden, NJ? The north side of Philly? The “wrong” side of Detroit’s 8 Mile Road? Nope.


The beautiful town of North Castle, NY, home to the hamlet of Armonk, NY, and headquarters of International Business Machines Corp. (NYSE:IBM), one of the largest welfare recipients in the world.

The typically SNAP (“food stamp”) recipient gets about $133.85 per month or about $25,699 if they were to remain on food stamps for 16 years. As you might imagine “food stamps” for IBM are a bit more expensive. From 1991 to 2007, IBM cashed in on $49.2M in ATP grants from the federal government.

All together, the federal Joint Committee on Taxation estimates that $154B, that’s BILLION with a ‘B’, will be spent on special corporate tax breaks and other subsidies in 2013.

The scale of the largesse is staggering. The average American family is paying an extra $3,693 to $4,423 in taxes to subsidize all of this corporate welfare. The average American family is paying about $870 to $1,600[1] per year for corporate tax subsidies, $1,231[2] in extra taxes to make up for corporate tax revenue lost to tax havens, $722[3] because of bank interest rate subsidies, and $870[4] for direct grants to corporations.

As someone once said, “I want either less corruption or more opportunity to participate in it.”

We bought International Business Machines Corp. (NYSE:IBM) stock (more on that purchase at a later date).

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