July 22, 2021
Tobin’s Q is the ratio of the market price of assets relative to their replacement cost and it indicates differences between financial and economic realms. Generally, the value of capital stock is the same as its replacement cost. If the price of existing capital stock is much higher than its replacement cost, then there is incentive to build anew. If the existing capital stock is cheaper than it costs to replace it, then capital formation will drop until its value returns to a level that justifies building more. Things stray from fair value because of speculative fervor and the difficulty in pricing intangibles.
Tobin’s Q ratio is at an all-time high - narrowly beating the past record, which occurred with the market downturn of the early 2000's. While we can't know if we’re in for a "market break," it’s clear that we are in a vulnerable state. If a market shock were to occur, it’s more likely that things could go further south than typical. In short, the tail is fatter.
Tobin’s Q is not the only measure of overvaluation. Fabric Co-Founder Rick Bookstaber recently posted about the current state of other fundamental valuation metrics such as price to earnings and price to book here.
All portfolios aren’t equally susceptible to market shocks. Some are more exposed than others and the sources of that exposure also vary between portfolios. That’s why Fabric for Advisors uses MSCI’s factors. Factors give you the most granular view possible so that you can make the best decisions with your clients.