Which Stock Market Is Scarier: U.S. or China?

 

It’s scary stock-market ratio day! Bloomberg’s Lu Wang and Jennifer Kaplan point out that economist James Tobin’s Q ratio — companies’ market value divided by the replacement cost of their assets — is higher for U.S. companies “than any time other than the Internet bubble and the 1929 peak.” Meanwhile, FT Alphaville tells of a Macquarie report on margin lending in China, which now accounts for 8.9 percent of the combined free float of the Shanghai and Shenzhen stock markets. That “could already be the highest level of margins vs free float in market history.”

First, Tobin’s Q. Tobin, who died in 2002, was a Nobel-winning Yale macroeconomist who was very interested in financial markets. An article he wrote in 1958 was key to the development of modern portfolio theory, the approach to investing that gave us efficient frontiers, asset allocation, index funds, beta and all that. Then, in 1985, he helped start the alternative investing boom by recommending that his former doctoral student David Swensen take over Yale’s endowment, which Swensen transformed into a market-beating assortment of private equity, hedge funds, forests and other interesting things. Tobin was also the model for a character in his Navy buddy Herman Wouk’s book “The Caine Mutiny,” although he doesn’t appear to have made it into the movie.

The Q ratio — the Q stands for quotient, so yes, “Q ratio” is a bit like saying “ATM machine” — is an economist’s version of the price-to-book ratio, a venerable market metric. The difference is that while book value is an accounting measure largely derived from the prices at which assets were purchased, the denominator in Q is supposed to reflect what it would cost to replace those assets.

As a conceptual matter, Q is clearly better than price-to-book. But figuring out the replacement value of a company’s assets is hard, so for the most part nobody uses Q in valuing individual equities. On a national level, though, the Federal Reserve does estimate the replacement value of the assets of nonfinancial corporate businesses. This is most often used to calculate a variant of Tobin’s Q sometimes called “Equity Q,” which is the stock market value of businesses divided by their net worth (assets minus debt and other liabilities). In fact, the Federal Reserve Bank of St. Louis will calculate it for you, going back more than half a century: