q = (value of stock market) / (replacement cost)
Or written differently
q = P/B
where P is the price all the stocks of all the companies and B is the book price of what it would cost if we were to build the companies from scratch. In essence, q is a measurement of stock market valuation relative to their assets.
Figure 1 shows historical q for U.S. corporations. It has varied widely over time depending on business cycle, inflation expectations, and most importantly, the investor sentiment. The average q = 0.71 indicating that historically the corporations have traded below their replacement value. Currently q = 1.1 which is historically high. Only during the internet bubble years has Topin's q been higher.
Figure 1: The U.S. stock market Tobin's q.
Valuation is not a good indicator for near term market movement but it can be used to estimate longer term stock market returns. Over several years, the valuation metrics tend to revert to to long term mean. We can use this fact to estimate the future stock market return by writing the price N years into the future as
Here qAVE is the historical average q, qNOW is the current q value, g is the average growth rate for the assets, and PNOW is the current stock valuation (Geek note: derivation at the end of this article). Note that this relationship does not account for dividends.
Figure 2 shows the modeled annualized stock market returns and actual realized returns over the 7 year time span. The plot does not account for dividends and is not adjusted for inflation. Currently, the projected return is negative. With dividends included, the nominal 7 year return is about break even meaning that one could just hold the cash and avoid the stock market risk.
Figure 2: The stock market return estimate based on Tobin's q ratio.
APPENDIX: The derivation between the current stock market price and future price estimate using q ratio:
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