James Tobin developed the Q ratio to estimate the fair value of the stock market (which can be applied to the S&P 500). The Q ratio is the total price of the market divided by the replacement cost of all companies in that market. The U.S. government gathers the data to do the calculation and the statistics are supplied in the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly. The Q ratio is not a timely metric to predict short term stock market movements or valuation discrepancies; the statistic is better suited for setting expectations of long term market performance.
Tobin’s Q ratio for U.S. equities
According to Doug Short from Advisor Perspectives, Tobin’s Q ratio for U.S. equities as represented by the S&P 500 (INDEXSP:.INX) is 1.08, which is above the long term average of 0.7. Tobin’s Q above 0.7 suggests the market is overvalued. The 1.08 reading is 54 percent more than the historic average. An overvaluation of 54 percent could precede a market correction. The chart below sourced from dsshort.com, shows that today’s levels are close to market peaks.
Also see: A Look at Current S&P 500 Valuation By Sector
Overestimation of replacement cost
Having 0.7 as a long term average instead of 1.0 indicates that companies overestimate their replacement cost, according to Smithers & Co. The firm indicates that long-term real return on corporate equity, according to the published data, is only 4.8 percent, while the long-term real return to investors is around 6.0 percent. Over the long-term and in equilibrium, the two must converge.
See: S&P 500 Valuation Spread at 25 Year Low
S&P 500 dividend yield
Another measure that suggests overvaluation is the S&P 500 (INDEXSP:.INX) dividend yield. It currently stands at 1.96 percent, close to its 1.11 percent minimum reached on August 2000. The long term dividend yield average stands at 4.44 percent. Accommodative monetary policy has encouraged investors to reach for yield and accept lower returns on securities that have required higher risk premiums over time. Even though some companies are increasing dividend payments, a stock price correction may be needed for dividend yields to return to average levels.
The S&P 500 Shiller Price to Earnings Ratio (price/average inflation adjusted earnings for the past 10 years) suggests overvaluation of the U.S. stock market. The measure is at 24.31, above its long term average of about 16.48 and its median of 15.89. The charts presented below are sourced from multpl.com.
Stock market correction
S&P 500 (INDEXSP:.INX) earnings per share stands at 87.99, close to its maximum of 95.17 reached on June 2007. Profits are growing at a slower pace in the second quarter of 2013, and the stock market could correct if profit growth continues to slow. Also, it is unlikely that S&P earnings per share will approach its maximum level, as the economic backdrop is not conducive to revenue growth or further cost reductions.
Consumers are still recovering from the impact of the 2008 recession and are reluctant to increase spending as wage growth has barely kept pace with inflation. Businesses are close to having maximum productivity and hiring has not picked up like in prior recoveries, in turn limiting opportunities to restructure.