EQUITIES AND TOBIN’S Q

With

Edited by the Research Team of

“The miserable failures of capitalist economies in the Great Depression were root causes of worldwide social and political disasters.” —James Tobin

Dear Subscriber,
In this time of market turmoil, Tobin’s Q ratio is being widely misinterpreted by equity investors. The following are highlights of our proprietary research:  We estimate Tobin’s Q at 0.50, well below parity and well below an adjusted average of 0.71 for the period from 1900-2008. Our data shows that Q has declined sharply this year through December 16th, down from 0.95 at yearend 2007 and down from 0.70 at the end of September. The numerator (market value) and denominator (replacement cost) of the Q ratio are down 45% and up 5%, respectively, from yearend 2007 through December 16th.  Despite the low value of today’s Q ratio, it sends only a modestly bullish signal for investors. Of the seven other instances since 1900 when Q fell to 0.50 or below, it was higher one year later in four instances. Five out of seven times, it was higher three years after the drop. Ten years after the drop, it was higher in all but one instance: When Q fell from 0.57 in 1941 to 0.43 in 1942, it rebounded initially but was lower a decade later, at 0.36 in 1952.  We cannot overemphasize the possibility of Q reaching extreme levels. The ratio hit a low of 0.29 twice over the course of the past century—in 1948 and 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949.  Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.50 is highly bullish if Q is on the upswing, but when the ratio is on the downswing, a value of 0.50 is only modestly bullish.  Those who argue that today’s Q sends an extremely bearish signal appear to be making three cognitive errors:  Undue focus on historical lows. While the low of 0.29 is materially below today’s Q, attempting to buy equities at or close to Q’s lows would have caused investors to miss out on decades of strong equity returns.  Ignorance of the fact that the relationship between Q and stock prices is not quite linear. We estimate that a 50% drop in Q from current levels would be accompanied by a 33% drop in major stock market indices.  Ignorance of the fact that replacement cost, the denominator of the Q ratio, has increased each year since 1946. As a result, future increases in replacement cost, driven primarily by inflation, should continue to exert upward pressure on market value.

John Mihaljevic, CFA
Managing Editor,

The Manual of Ideas
john@manualofideas.com

About This Report
Equities and Tobin’s Q, 1900-2008
—Evaluating the Market Outlook in the Context of a Century of History Report Date: December 17, 2008 Publishing Frequency: Quarterly Website: www.manualofideas.com/q

Inside This Report
Quarterly Update ……………… p. 1 Today’s Q: Bullish or Bearish? … p. 2 Economic Rationale …………… p. 3 Q in Investment Management … p. 4 Putting Q in Historical Context … p. 5 Q and Warren Buffett ………… p. 6 Calculating Tobin’s Q ………… p. 7 Selected Charts and Data ……… p. 9 Additional Resources ………… p. 17

About The Author
John Mihaljevic served as James Tobin’s research assistant from 1996-98 and worked with Professor Tobin to refine the Q estimation method. Mr. Mihaljevic was also involved in various research projects at the Cowles Foundation, including researching and editing James Tobin’s Money, Credit and Capital. Mr. Mihaljevic, CFA, graduated summa cum laude from Yale, having earned distinction in the study of economics. In addition to working for and studying under James Tobin, Mr. Mihaljevic also studied under Yale Chief Investment Officer David Swensen and Sterling Professor of Economics William Nordhaus. Mr. Mihaljevic has worked as an investment banker, equity research analyst and investment manager. He currently serves as managing member of Mihaljevic Capital Management LLC and managing editor of The Manual of Ideas.

Until our next Tobin’s Q update,
Sincerely,

EQUITIES AND TOBIN’S Q is published quarterly by BeyondProxy LLC, P.O. Box 1375, New York, NY 10150. Website: www.manualofideas.com. Email: support@manualofideas.com. Please email or call if you have any subscription questions. Managing Editor: John Mihaljevic. Subscription $399 per year. © Copyright 2008 by BeyondProxy LLC. All rights reserved. Photocopying, reproduction, quotation, or redistribution of any kind is strictly prohibited without written permission from the publisher. This report bases recommendations and forecasts on techniques and sources believed to be reliable in the past and cannot guarantee future accuracy and results. BeyondProxy’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this report. John Mihaljevic, Chairman of BeyondProxy, is also a principal of Mihaljevic Capital Management LLC (“MCM”), which serves as the general partner of a private investment partnership. MCM may purchase or sell securities and financial instruments discussed in this report on behalf of the investment partnership or other accounts it manages. It is the policy of MCM and all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities or financial instruments discussed herein are made. Use of this report and its content is governed by the Terms of Use described in detail at www.manualofideas.com/terms.html.

EQUITIES AND TOBIN’S Q — December 2008
THE DEBATE Is Today’s Q Giving a Bullish or Bearish Signal for Equities?

Tobin’s Q Ratio, 2000–2008 1,2
2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Source: The Federal Reserve; Blanchard, Rhee, and Summers; The Manual of Ideas.

Disagreement between leading investment managers and strategists has been remarkable. Consider the diametrically opposed views of two prominent figures:  Bill Gross, the outspoken Managing Director of PIMCO, a leading global investment firm with more than $790 billion in assets under management, asserts that the “Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation...” Access Bill Gross’s full December 2008 Investment Outlook:
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+Dow+5000+Gross+Dec+08.htm

 Russell Napier, Strategist at CLSA, a leading international brokerage and investment group, claims that the Q ratio supports his expectation of a “horrific” market bottom and another 55% drop in the S&P 500 Index by 2014. Access the full article:
http://www.bloomberg.com/apps/news?pid=20601087&sid=a6iiap2DL_gQ

Based on our proprietary analysis and the data presented in this report, we conclude that today’s estimated Tobin’s Q ratio of 0.50 sends a modestly bullish signal for equity investors.

1 2

As of December 16, 2008. This chart consists of two data sets: (1) 1900-1944: We use a modified Blanchard, Rhee, Summers data series. We adjust data in the series downward to reflect the series’ upward bias as compared to the Tobin (new) methodology developed by James Tobin and John Mihaljevic. (2) 1945-2008: We use the Tobin (new) data series, updated through December 16, 2008. We believe this combined set of data from 1900-2008 provides the most accurately historical rendering of the Q ratio.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 2

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EQUITIES AND TOBIN’S Q — December 2008
BACKGROUND Tobin’s Q — Economic Rationale
Tobin conceptualized the Q ratio as a measure of over- or undervaluation of publicly traded assets. In its simplest form, Q equals market value divided by replacement cost.  If the market value of an asset exceeds the cost of replacing it (Q>1), an incentive exists to recreate the asset and immediately sell it in the market at a premium to cost. As a result, incremental real investment will tend to force high Q ratios back down to parity (Q1).  No straightforward balancing mechanism exists in the case of low Q ratios, i.e., when the market is valuing an asset below its replacement cost (Q<1). When Q is less than parity, the market seems to be saying that the deployed real assets will not earn a sufficient rate of return and that, therefore, the owners of such assets must accept a discount to the replacement value if they desire to sell their assets in the market. If the real assets can be sold off at replacement cost, for example via an asset liquidation, such an action would be beneficial to shareholders because it would drive the Q ratio back up toward parity (Q1). In the case of the stock market as a whole, rather than a single firm, the conclusion that assets should be liquidated does not typically apply. A low Q ratio for the entire market does not mean that blanket redeployment of resources across the economy will create value. Instead, when market-wide Q is less than parity, investors are probably being overly pessimistic about future asset returns. A critique of Tobin’s Q may include the following observations:  Q may be less relevant in an economy increasingly driven by intellectual property. As the Q ratio does not consider the replacement cost of intangible assets (although it does include software), critics have pointed out that a “fair value” of Q should be higher today than several decades ago. We agree that an “equilibrium” value of Q is likely increasing slowly over time, but we also note that Q remains an important and reliable indicator of asset overvaluation. The Q ratio sent a strikingly bearish signal at the height of the Internet bubble, despite some critics’ observation at the time that the Q ratio should not have been relied upon because it excluded intangible assets.  The economic rationale behind the Q ratio is sound, but the underlying adjustment mechanism may take longer than most equity market investors can tolerate. We agree with the observation that Tobin’s Q should not be used a short-term market timing tool. The Q ratio derives its mean-reverting property from processes that take place in the real economy and, therefore, do not happen overnight. As a result, it may take years for the market value of equities to align closely with levels suggested by the Q ratio. However, at extreme levels of Q — below 0.40 or above 1.50 — Q’s short-term signaling power increases markedly. As a result, in times of extreme market dislocation, the Q ratio may be able to provide some guidance even to investors with relatively short time horizons.

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Edited by the Research Team of The Manual of Ideas

www.manualofideas.com/q

3

EQUITIES AND TOBIN’S Q — December 2008
INVESTMENT MANAGEMENT The Q Ratio as an Input into Investment Decision-Making Processes
Several studies have shown that stock market investments at times when the Q ratio was less than parity have produced above-average long-term returns. For example, Matthew Harney and Edward Tower, authors of “Rational Pessimism: Predicting Equity Returns using Tobin’s q and Price/Earnings Ratios,” summarize their conclusion as follows: “We discover that q beats all variants of the PE ratio for predicting real rates of return over alternative horizons.” Access the Harney and Tower paper as follows: http://www.econ.duke.edu/Papers/Abstracts02/abstract.02.29.html The Manual of Ideas has analyzed three series of historical data on Tobin’s Q in order to draw conclusions on specific Q values that might be used as buy or sell signals for U.S. equities.  The data series include James Tobin’s “old” and “new” methodologies and data provided by Olivier Blanchard, Chanyong Rhee and Larry Summers in 1992.  The Tobin (new) methodology was developed jointly by James Tobin and John Mihaljevic in 1996-97. The Tobin (new) dataset accompanies this report and is available in Excel.  Blanchard, Rhee and Summers (BRS) calculated the Q ratio going back to 1900. Their calculation showed Q at 1.26 in 1929, immediately prior to the Great Depression. Due to their series’ upward bias as compared to the Tobin (new) methodology, we adjust the BRS estimate of Q downward to 1.06 for 1929. Similarly, we adjust their low estimate of Q of 0.36 in 1932 down to 0.30.

Based on the adjusted BRS series and the Tobin (new) series, we conclude that a successful market-timing strategy during the 20th century would have been to buy U.S. equities when the Q ratio hit 0.40 or below, and to sell U.S. equities when then Q ratio hit 1.00.1

Tobin’s Q Ratio — Historical Buy and Sell Signals, 2000–2008 2
2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1900 1910

Sell Sell Sell Sell Sell Sell

Buy
1920

Buy
1930 1940

Buy
1950 1960

Buy
1970

Buy
1980 1990 2000

Source: The Federal Reserve; Blanchard, Rhee, and Summers; The Manual of Ideas.

It is noteworthy that empirical evidence suggests that a parity Q ratio (Q=1) should have been read as a sell signal. Without the benefit of historical experience, one might have assumed that Q=1 merely signaled fair value. However, if one adopts a “bargain hunter” mentality, it is quite easy to agree that it makes little sense to buy assets at market prices when such prices exceed replacement cost, even if the premium is very small. Entrepreneurship drives the American capitalist system, and the empirical parity Q sell signal suggests that, investment costs being equal, Americans have preferred to start a new business rather than invest in an existing one. 2 As of December 16, 2008.
© BeyondProxy LLC. All rights reserved. Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 4

1

EQUITIES AND TOBIN’S Q — December 2008
INVESTMENT MANAGEMENT Putting Today’s Q Ratio In Historical Context
 We estimate Tobin’s Q at 0.50, well below parity and well below an adjusted average of 0.71 for the period from 1900-2008. Our data shows that Q has declined sharply this year through December 16th, down from 0.95 at yearend 2007 and down from 0.70 at the end of September. The decline from 0.70 to 0.50 reflects a 21.2% decline in the S&P 500 Total Return Index from September 30th through December 16th, 2008.  Despite the low value of today’s Q, it sends only a modestly bullish signal for investors. Of the seven other instances since 1900 when Q fell to 0.50 or below, it was higher one year later in four instances. Five out of seven times, it was higher three years after the drop. Ten years after the drop, it was higher in all but one instance: When Q fell from 0.57 in 1941 to 0.43 in 1942, it rebounded initially but was lower a decade later, at 0.36 in 1952.

Analysis of Instances When Q Declined to 0.50 or Below, 1900-2008 1
What Happened 19161917                       Q fell from 0.65 in 1916 to 0.45 in 1917 Q fell further in 1918, ending the year at 0.33 Q eroded further, hitting 0.30 in 1921 Q fell from 0.59 in 1931 to 0.30 in 1932 Q rebounded to 0.48 in 1933 It continued to rise in subsequent years, hitting a high of 1.08 in 1936 Q fell from 0.57 in 1941 to 0.43 in 1942 Q rebounded in to 0.54 in 1943 It declined in subsequent years, hitting a low of 0.29 in 1948 Q fell from 0.53 in 1944 to 0.48 in 1945 Q fell further to 0.39 in 1946 Q continued to decline, hitting a low of 0.29 in 1948 Q fell from 0.55 in 1956 to 0.47 in 1957 Q rebounded to 0.62 in 1958 It continued to rise in subsequent years, hitting a high of 1.05 in 1968 Q fell from 0.61 in 1973 to 0.29 in 1974 Q rebounded to 0.49 in 1975 It rose again to 0.53 in 1976 but then embarked on another decline Q fell from 0.53 in 1976 to 0.43 in 1977 Q fell further to 0.40 in 1978 It rose to 0.41 in 1979 but did not remain on a consistent path in subsequent years Q fell from 0.95 at yearend 2007 to 0.70 at the end of 3Q08 and to 0.50 as of December 16, 2008 Was Q Higher or Lower In Years Following Drop to 0.50 or Below  One year later: Q was lower  Three years later: Q was lower  Five years later: Q was lower  Ten years later: Q was higher  One year later: Q was higher  Three years later: Q was higher  Five years later: Q was higher  Ten years later: Q was higher  One year later: Q was higher  Three years later: Q was higher  Five years later: Q was lower  Ten years later: Q was lower  One year later: Q was lower  Three years later: Q was lower  Five years later: Q was lower  Ten years later: Q was higher  One year later: Q was higher  Three years later: Q was higher  Five years later: Q was higher  Ten years later: Q was higher  One year later: Q was higher  Three years later: Q was higher  Five years later: Q was higher  Ten years later: Q was higher  One year later: Q was lower  Three years later: Q was higher  Five years later: Q was lower  Ten years later: Q was higher

19311932

19411942

19441945

19561957

19731974

19761977

20072008

Source: The Manual of Ideas analysis.

 We cannot overemphasize the possibility of Q reaching extreme levels. The ratio hit a low of 0.29 twice over the course of the past century—in 1948 and 1974. The ratio was 0.33 or lower in 1918-1921, 1932, and 1949.  Those who argue that today’s Q sends an extremely bullish signal appear to focus solely on the level of Q, ignoring the direction of change. A ratio of 0.50 is very bullish if Q is on the upswing, but when Q is in decline, a value of 0.50 is only modestly bullish.

1

Based on adjusted Q ratio estimates from 1900-2008.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 5

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EQUITIES AND TOBIN’S Q — December 2008
INVESTMENT MANAGEMENT Warren Buffett’s Intuitive Use of The Q Ratio
Buffett is famous for advocating investment in businesses with wide moats, i.e., with sustainable competitive advantage. As the following quote from Buffett shows, this idea dovetails nicely with the concept of replacement value (Tobin’s Q). The cost of “replacing” a business with a wide moat would likely be significantly higher than the GAAP book value of that firm. Said Buffett, “The test of a franchise is what a smart guy with a lot of money could do to it if he tried. If you gave me a billion dollars, and first draft pick of fifty business managers throughout the United States, I could absolutely cream both the business world and the journalistic world. If you said, “Go take the Wall Street Journal apart,” I would hand back the billion dollars. Reluctantly, but I would hand it back to you. The real test of a business is how much damage a competitor can do, even if he is stupid about returns. The trick is to find the ones that haven’t been identified by someone else.” 1 By citing the Wall Street Journal as an example of a company with a wide moat, Buffett may have wanted to point out that some companies have built value over time, value that cannot be equaled even if significant capital is deployed to create a replica. Those companies have components of value into which financial capital is not readily convertible. In other words, those aspects of value (e.g., reputation, long-term customer contracts) have evolved over time or for other non-financial reasons and can only be reasonably replaced through similar processes. Most of Buffett’s equity investments are good examples of companies with wide moats, including Coca-Cola, GEICO, Wells Fargo, Gillette, and American Express. We would argue that the following companies also have wide moats and would be great long-term investments at the appropriate price: Sony, due to its brand and design leadership in consumer electronics, despite high competition and pricing pressure in its industry; BMW, due to a defensible niche and intensely loyal customer base, despite tough industry conditions; and eBay, due to large barriers to entry and scale advantage.

A note on using replacement value as a basis for investment decisions: It is a necessary but not sufficient condition that the replacement cost of a company exceed the equity market value. If replacement value is below market value, competitors are likely to enter the industry. If replacement value exceeds market value, the investor should verify that returns on invested capital exceed the cost of capital. There is no use investing in a company with a high replacement value if no one would want to “replace” it anyway because of unattractive industry conditions.

1

Train, John, Money Masters of Our Time (New York, New York: HarperCollins Publishers, 2000): 16-17.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 6

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EQUITIES AND TOBIN’S Q — December 2008
MECHANICS Calculating Tobin’s Q
Tobin’s Q is impossible to calculate with precision, as the concept of replacement value is inherently subjective. For example, rational investors are likely to disagree on the replacement value of The Coca-Cola Company, as investors will have divergent views on the value of Coke’s brand equity. As a result, the calculation of q requires a number of estimates and approximations. In this report, we focus on estimating Q for the market as a whole rather than any single stock. The data used to estimate Q can be found in the Federal Reserve Board’s Z.1 statistical release entitled Flow of Funds Accounts of the United States. Before proceeding with this brief tutorial, we suggest that you access the FRB’s website and print out the relevant page from the latest Z.1 release. To do so, simply go to http://www.federalreserve.gov/releases/z1/ and click on the date of the current Z.1 release. Then click on PDF file labeled “Balance sheet tables.” The file will contain several pages, but you only need the page entitled “B.102 Balance Sheet of Nonfarm Nonfinancial Corporate Business.” All references below to lines that contain certain data relate to line numbers in the B.102 table. For your convenience, we have reproduced on the next page the data used to calculate Q from 1945 thru 2008.

Q = (market value of debt & equities – net liquid assets – land value) / replacement cost of structures, equipment & software, and inventories,

where  The market value of debt can be estimated by using book value of debt as a proxy for market value; book value of debt outstanding in any particular year is the sum of the following line items contained in balance sheet B.102 of statistical release Z.1: Municipal Securities (line 24), Corporate Bonds (line 25), and Mortgages (line 28).1 The market value of equities is found in line 35 of B.102. Equity market value can be updated through the present by adjusting the value provided in the Z.1 statistical release to reflect the subsequent change in a major market index, such as the S&P 500 Index. Net liquid assets = total financial assets – (total liabilities – municipal securities – corporate bonds – mortgages) = line 6 – (line 21 – line 24 – line 25 – line 28) Land value is approximated as the market value of real estate – the replacement cost of residential and nonresidential structures, i.e., land value = line 3 – line 33 – line 34. The replacement cost of structures, equipment & software, and inventories is the sum of lines 4, 5, 33, and 34 of B.102.

  

1

It is possible to estimate the market value of debt more accurately than by using book value as a proxy. In order to do so, long-term debt can be modeled in the form of 10-year, Baa-grade bonds with semiannual coupons. (Historical data on Moody’s Baa interest rates is available on the FRB’s website.) The market value of the debt outstanding in year t would then equal the sum of the market values of debt issued in years t-9 through t. The book value of bonds issued in year t equals the book value of debt outstanding in year t (calculated as noted in text above) minus the book value of debt outstanding in year t-1 plus the book value of debt outstanding in year t-10. The market value of debt issued in year t can be estimated as the book value of debt issued in year t. The market value of debt issued in years t-9 through t-1 can be estimated via a net present value formula using the applicable Moody’s Baa interest rates.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 7

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EQUITIES AND TOBIN’S Q — December 2008

The table below shows data inputs for the following formula: Q = = = market value / replacement cost = (market value of debt & equities – net liquid assets – land value) / replacement cost of structures, equipment & software, and inventories mv / rc = (mvd + mve – nla – lv) / (rcs + rces + rci)

Calculating Tobin’s Q — Key Variables, 1945–2008 1
q Tobin's Q 0.48 0.39 0.31 0.29 0.30 0.35 0.38 0.36 0.34 0.46 0.55 0.55 0.47 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.70 0.50 mv Market Value 84 81 76 77 82 106 127 125 122 170 220 244 222 297 336 344 413 400 444 527 606 544 712 849 725 726 838 1,028 802 468 867 1,025 924 980 1,165 1,479 1,387 1,550 1,741 1,671 2,107 2,425 2,483 2,742 3,389 3,449 4,711 5,527 6,211 6,145 7,694 8,878 10,743 12,360 14,890 11,829 10,343 7,410 9,870 10,715 10,900 11,906 11,581 8,980 6,380 rc Replacement Cost 176 206 242 266 271 300 332 348 362 371 402 444 470 477 492 505 517 535 554 583 624 684 741 807 888 970 1,053 1,148 1,311 1,589 1,759 1,939 2,154 2,442 2,815 3,229 3,606 3,788 3,895 4,135 4,313 4,450 4,689 4,995 5,258 5,511 5,603 5,770 6,041 6,396 6,743 7,045 7,410 7,680 7,922 8,470 8,755 8,997 9,231 9,960 10,822 11,642 12,230 12,836 12,836 mvd Book Value of Debt 33 35 39 45 49 52 56 62 66 71 76 80 88 96 100 105 111 119 126 134 142 157 176 192 208 232 255 275 315 338 373 403 447 487 516 544 588 619 682 765 868 1,001 1,127 1,242 1,333 1,387 1,454 1,506 1,585 1,625 1,738 1,864 2,017 2,269 2,553 2,754 3,165 3,349 3,593 3,728 3,994 4,308 4,727 4,886 mve Market Value of Equities 104 97 95 94 104 127 148 147 144 195 244 268 246 325 362 365 438 424 466 546 624 548 712 843 714 712 836 1,049 820 562 761 935 825 864 1,028 1,346 1,225 1,386 1,630 1,553 1,917 2,241 2,287 2,559 3,145 2,967 4,014 4,370 4,852 4,812 6,435 7,619 9,661 11,561 15,160 12,685 10,805 7,839 10,845 12,086 12,687 14,340 15,243 12,268 nla Net Liquid Assets 32 22 22 25 33 31 30 36 39 46 46 43 46 56 59 56 62 66 68 69 69 64 73 73 68 74 93 116 123 186 -8 9 7 -16 -67 -95 -143 -164 -86 -52 -61 46 120 188 153 102 171 82 211 259 448 572 677 902 2,239 2,915 3,255 3,368 3,834 4,310 4,758 5,264 6,017 6,074 lv Land Value 21 29 37 37 38 42 47 48 50 50 55 62 66 68 68 70 74 77 80 84 91 97 104 114 130 144 161 180 210 245 275 304 341 387 445 506 569 619 658 700 739 772 811 871 936 803 586 267 14 34 31 33 257 568 583 695 373 411 734 789 1,023 1,479 2,372 2,099 rcs rces rci Replacement Cost of Structures Equipment Inventories & Software 111 32 33 130 39 36 151 48 42 162 56 47 166 61 43 178 69 53 194 77 61 203 83 62 209 89 63 215 94 62 230 104 69 251 117 76 263 129 78 269 134 74 275 141 77 280 146 80 285 150 82 292 156 87 299 163 93 310 173 99 329 187 108 350 210 124 375 232 134 406 257 144 445 285 159 489 314 167 542 336 175 599 360 189 686 400 226 802 495 292 896 567 295 981 629 330 1,079 709 366 1,213 806 423 1,379 934 501 1,574 1,087 568 1,773 1,212 621 1,896 1,280 612 1,930 1,332 634 2,032 1,400 703 2,115 1,485 713 2,164 1,576 709 2,273 1,652 765 2,417 1,751 827 2,536 1,854 869 2,637 1,972 901 2,668 2,048 887 2,745 2,123 902 2,886 2,220 935 3,040 2,349 1,007 3,172 2,501 1,070 3,321 2,633 1,091 3,499 2,770 1,140 3,635 2,865 1,180 3,806 2,864 1,252 4,069 3,067 1,334 4,322 3,167 1,266 4,474 3,220 1,303 4,635 3,250 1,345 5,129 3,351 1,480 5,719 3,501 1,602 6,229 3,715 1,698 6,532 3,896 1,802 6,889 4,038 1,910

Year 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08 12/16/08

Source: The Federal Reserve, The Manual of Ideas.

1

As of December 16, 2008.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 8

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EQUITIES AND TOBIN’S Q — December 2008
SELECTED CHARTS AND HISTORICAL DATA Tobin’s Q — Tobin (New) Methodology, 1945–2008 1
2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0 1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Source: Federal Reserve, The Manual of Ideas.

1

As of December 16, 2008.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 9

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Comparative Chart, 1900–2008 1
2.00

1.80

1.60

Tobin (New)

1.40 Blanchard, Rhee, and Summers 1.20 Tobin (Old)

1.00

0.80

0.60

0.40

0.20 1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Source: Federal Reserve, The Manual of Ideas.

1

As of December 16, 2008.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 10

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Comparative Chart, 1950–2008 1
2.00

1.80

1.60

1.40

1.20

1.00 Blanchard, Rhee, and Summers Tobin (Old) Tobin (New)

0.80

0.60

0.40

0.20 1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Source: Federal Reserve, The Manual of Ideas.

1

As of December 16, 2008.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 11

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Summary Data (incl. Unadjusted Blanchard, Rhee, Summers), 1900-2008(Q3) 1 2
  
Year 1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Q average value: 0.76; Q median value: 0.75 Q minimum value: 0.29 (1948 and 1974); Q maximum value: 1.88 (1999) Q less than 1.00 (number of years): 84; Q greater than 1.00 (number of years): 25
Tobin’s Q 0.61 0.81 1.24 0.99 1.09 1.28 1.19 0.90 0.93 1.06 1.03 0.97 0.99 0.98 0.79 0.81 0.78 0.54 0.40 0.39 0.39 0.36 0.47 0.50 0.50 0.63 0.68 0.79 0.98 1.26 1.11 0.71 0.36 0.57 0.91 1.17 1.28 1.15 0.89 1.08 Year 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Tobin’s Q 0.82 0.67 0.51 0.64 0.63 0.48 0.39 0.31 0.29 0.30 0.35 0.38 0.36 0.34 0.46 0.55 0.55 0.47 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08 th Dec. 16 Tobin’s Q 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.70 0.50

Source: Federal Reserve, The Manual of Ideas.

Data shows estimated Tobin’s Q ratio at each yearend, unless otherwise noted. Data from 1900-1944 is derived from Blanchard, Rhee, Summers series of Q estimates; data from 19452008(Q3) represents Tobin’s Q estimates based on Tobin’s Q (new) methodology.
2

1

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Summary Data (incl. Adjusted Blanchard, Rhee, Summers), 1900-2008(Q3) 1 2 3
  
Year 1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Q average value: 0.71; Q median value: 0.68 Q minimum value: 0.29 (1948 and 1974); Q maximum value: 1.88 (1999) Q less than 1.00 (number of years): 92; Q greater than 1.00 (number of years): 17
Q Ratio (Adjusted) 0.51 0.68 1.04 0.83 0.91 1.08 1.00 0.76 0.78 0.89 0.87 0.82 0.83 0.82 0.66 0.68 0.65 0.45 0.33 0.33 0.33 0.30 0.39 0.42 0.42 0.53 0.57 0.66 0.82 1.06 0.93 0.59 0.30 0.48 0.76 0.98 1.08 0.97 0.75 0.91 Year 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 Q Ratio (Adjusted) 0.69 0.57 0.43 0.54 0.53 0.48 0.39 0.31 0.29 0.30 0.35 0.38 0.36 0.34 0.46 0.55 0.55 0.47 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08 th Dec. 16 Q Ratio (Adjusted) 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.70 0.50

Source: Federal Reserve, The Manual of Ideas.

1 Data from 1900-1944 is derived from Blanchard, Rhee, Summers series of Q estimates; data from 19452008(Q3) represents Tobin’s Q estimates based on Tobin’s Q (new) methodology. 2 Blanchard, Rhee, Summers series of Q estimates has been adjusted to conform more closely to Tobin’s Q (new) methodology used for years 1945-2008. The adjustment is based on an analysis of overlapping Q estimates for the period from 1945-1990, for which both methods provide a set of estimates. Our analysis found that the Blanchard, Rhee, Summers estimates exceeded the Tobin (new) estimates by 19%, on average. As a result, the original Blanchard, Rhee, Summers series from 1900-1944 used in the table above has been adjusted as follows: Each Blanchard, Rhee, Summers data point from 1900-1944 was divided by 1.19. 3 Data shows estimated Tobin’s Q ratio at each yearend, unless otherwise noted.

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Numerator and Denominator, 1958-2008 (December 16th) 1
  YTD 2008: Numerator (market value) down 45%, denominator (replacement cost) up 5% Market value has exhibited significantly greater volatility than replacement cost
Tobin’s Q 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.50 Market Value $297 336 344 413 400 444 527 606 544 712 849 725 726 838 1,028 802 468 867 1,025 924 980 1,165 1,479 1,387 1,550 1,741 1,671 2,107 2,425 2,483 2,742 3,389 3,449 4,711 5,527 6,211 6,145 7,694 8,878 10,743 12,360 14,890 11,829 10,343 7,410 9,870 10,715 10,900 11,906 11,581 6,380 Replacement Cost $477 492 505 517 535 554 583 624 684 741 807 888 970 1,053 1,148 1,311 1,589 1,759 1,939 2,154 2,442 2,815 3,229 3,606 3,788 3,895 4,135 4,313 4,450 4,689 4,995 5,258 5,511 5,603 5,770 6,041 6,396 6,743 7,045 7,410 7,680 7,922 8,470 8,755 8,997 9,231 9,960 10,822 11,642 12,230 12,836 Changes in Market Replacement Value Cost 34% 2% 13% 3% 3% 3% 20% 2% -3% 3% 11% 4% 19% 5% 15% 7% -10% 10% 31% 8% 19% 9% -15% 10% 0% 9% 15% 9% 23% 9% -22% 14% -42% 21% 85% 11% 18% 10% -10% 11% 6% 13% 19% 15% 27% 15% -6% 12% 12% 5% 12% 3% -4% 6% 26% 4% 15% 3% 2% 5% 10% 7% 24% 5% 2% 5% 37% 2% 17% 3% 12% 5% -1% 6% 25% 5% 15% 4% 21% 5% 15% 4% 20% 3% -21% 7% -13% 3% -28% 3% 33% 3% 9% 8% 2% 9% 9% 8% -3% 5% -45% 5%

Year 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 th Dec. 16

Source: Federal Reserve, The Manual of Ideas.

1

Based on Tobin’s Q (new) methodology. U.S. dollars in billions.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 14

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Components of Numerator (Market Value), 1958-2008(Q3) 1
Tobin's Q 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.70 Market Value of 2 Debt $96 100 105 111 119 126 134 142 157 176 192 208 232 255 275 315 338 373 403 447 487 516 544 588 619 682 765 868 1,001 1,127 1,242 1,333 1,387 1,454 1,506 1,585 1,625 1,738 1,864 2,017 2,269 2,553 2,754 3,165 3,349 3,593 3,728 3,994 4,308 4,727 4,886 Market Value of Equities $325 362 365 438 424 466 546 624 548 712 843 714 712 836 1,049 820 562 761 935 825 864 1,028 1,346 1,225 1,386 1,630 1,553 1,917 2,241 2,287 2,559 3,145 2,967 4,014 4,370 4,852 4,812 6,435 7,619 9,661 11,561 15,160 12,685 10,805 7,839 10,845 12,086 12,687 14,340 15,243 12,268 Net Liquid 3 Assets $56 59 56 62 66 68 69 69 64 73 73 68 74 93 116 123 186 -8 9 7 -16 -67 -95 -143 -164 -86 -52 -61 46 120 188 153 102 171 82 211 259 448 572 677 902 2,239 2,915 3,255 3,368 3,834 4,310 4,758 5,264 6,017 6,074 Land Value – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – $68 68 70 74 77 80 84 91 97 104 114 130 144 161 180 210 245 275 304 341 387 445 506 569 619 658 700 739 772 811 871 936 803 586 267 14 34 31 33 257 568 583 695 373 411 734 789 1,023 1,479 2,372 2,099

Year 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08

Market Value $297 336 344 413 400 444 527 606 544 712 849 725 726 838 1,028 802 468 867 1,025 924 980 1,165 1,479 1,387 1,550 1,741 1,671 2,107 2,425 2,483 2,742 3,389 3,449 4,711 5,527 6,211 6,145 7,694 8,878 10,743 12,360 14,890 11,829 10,343 7,410 9,870 10,715 10,900 11,906 11,581 8,980

= = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = =

+ + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + +

– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Source: Federal Reserve, The Manual of Ideas.

Based on Tobin’s Q (new) methodology. U.S. dollars in billions. Generally approximated with book value of debt. Reliable market value aggregates are generally unavailable. While the market value of debt can be estimated by valuing debt tranches based on book value and an appropriate interest rate (typically Baa), such estimates can be unreliable. 3 Equals financial assets minus total liabilities (excl. municipal securities, corporate bonds and mortgages).
2

1

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EQUITIES AND TOBIN’S Q — December 2008
Tobin’s Q — Components of Denominator (Replacement Cost), 1958-2008(Q3) 1
Tobin's Q 0.62 0.68 0.68 0.80 0.75 0.80 0.90 0.97 0.80 0.96 1.05 0.82 0.75 0.80 0.90 0.61 0.29 0.49 0.53 0.43 0.40 0.41 0.46 0.38 0.41 0.45 0.40 0.49 0.54 0.53 0.55 0.64 0.63 0.84 0.96 1.03 0.96 1.14 1.26 1.45 1.61 1.88 1.40 1.18 0.82 1.07 1.08 1.01 1.02 0.95 0.70 Replacement Cost $477 492 505 517 535 554 583 624 684 741 807 888 970 1,053 1,148 1,311 1,589 1,759 1,939 2,154 2,442 2,815 3,229 3,606 3,788 3,895 4,135 4,313 4,450 4,689 4,995 5,258 5,511 5,603 5,770 6,041 6,396 6,743 7,045 7,410 7,680 7,922 8,470 8,755 8,997 9,231 9,960 10,822 11,642 12,230 12,836 Replacement Cost of 2 Structures Equipment Inventories & Software $269 $134 $74 275 141 77 280 146 80 285 150 82 292 156 87 299 163 93 310 173 99 329 187 108 350 210 124 375 232 134 406 257 144 445 285 159 489 314 167 542 336 175 599 360 189 686 400 226 802 495 292 896 567 295 981 629 330 1,079 709 366 1,213 806 423 1,379 934 501 1,574 1,087 568 1,773 1,212 621 1,896 1,280 612 1,930 1,332 634 2,032 1,400 703 2,115 1,485 713 2,164 1,576 709 2,273 1,652 765 2,417 1,751 827 2,536 1,854 869 2,637 1,972 901 2,668 2,048 887 2,745 2,123 902 2,886 2,220 935 3,040 2,349 1,007 3,172 2,501 1,070 3,321 2,633 1,091 3,499 2,770 1,140 3,635 2,865 1,180 3,806 2,864 1,252 4,069 3,067 1,334 4,322 3,167 1,266 4,474 3,220 1,303 4,635 3,250 1,345 5,129 3,351 1,480 5,719 3,501 1,602 6,229 3,715 1,698 6,532 3,896 1,802 6,889 4,038 1,910

Year 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 3Q08

1 2

Based on Tobin’s Q (new) methodology. U.S. dollars in billions. Includes replacement cost of residential and non-residential structures.
Edited by the Research Team of The Manual of Ideas www.manualofideas.com/q 16

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EQUITIES AND TOBIN’S Q — December 2008
BIBLIOGRAPHY Selected Sources of Additional Information
Harney, Matthew and Edward Tower, “Rational Pessimism: Predicting Equity Returns using Tobin’s q and Price/Earnings Ratios,” The Journal of Investing (forthcoming), January 2, 2003, accessed at http://www.econ.duke.edu/Papers/Abstracts02/abstract.02.29.html Board of Governors of the Federal Reserve System, Z.1 statistical releases and historical data, http://www.federalreserve.gov/releases/z1/current/default.htm Blanchard, Olivier, Changyong Rhee, and Lawrence Summers, “The Stock Market, Profit and Investment,” Quarterly Journal of Economics, Cambridge, Mass., June 1992. Tobin’s Q web page by The Manual of Ideas: http://www.manualofideas.com/q Tobin’s Q insight and snapshot of historical ratios by sector: http://wps.aw.com/aw_carltonper_modernio_4/0,9313,1424978-content,00.html James Tobin resource page at the New School: http://cepa.newschool.edu/het/profiles/tobin.htm

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