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.”
What are we to make of these ominous-sounding measures? Something. Definitely something.
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:
The main impression one gets from this chart is that wow, the late 1990s were really crazy. Beyond that, it’s clear that today’s stock market values are pretty high by historical standards. The 1960s were a boom time in U.S. stock markets, but Equity Q never topped 100 percent before the 1990s.
Still, U.S. corporations have changed a lot since the 1960s. Their value depends less on tangible assets such as land and factories and machines, and more on intangibles such as patents and brands. In 2013 the Bureau of Economic Analysis actually did begin estimating the value of intellectual property in gross domestic product calculations, and the Fed includes this in its measure of corporate assets. But it’s a conservative measure related directly to spending on research and development, and probably doesn’t reflect the full value of corporations’ intangibles.
On the other hand, the biggest category of corporate assets (at $11.2 trillion in the fourth quarter of 2014, according to the Fed, compared with $2 trillion for intellectual property) is real estate. That’s measured at market value -- meaning that a real estate bubble could help mask an equity bubble, if Q is your metric. In sum, it’s hard to know exactly what to make of long-run historical Q comparisons, but it’s definitely yet another measure showing that U.S. stock prices aren’t cheap. Not cheap and about to collapse are different things, though.
Then there’s China. The Shanghai Composite Index has more than doubled during the past year despite ample signs of an economic slowdown, as government efforts to discourage speculation in real estate seem to have shifted the action over to equity markets. Hence the explosion in margin lending. Here’s Macquarie again, via the FT:
It is possible that other bubble markets saw higher leverage (ie, the US in the decade-long boom that ended in 1929, Taiwan & possibly Japan in their 1980s bubbles) but we find it difficult to believe that leverage would have moved up as quickly as what has happened in China.
Still, China’s equity markets are quite small relative to the economy. And although I don’t know of any easy way to calculate China’s Q, the price-to-book ratio of the Shanghai composite is, at 2.5, lower than the Standard & Poor’s 500’s 2.9. The question in China is really a broader one -- can the Chinese government continue to manage the maturation and slowing of the country’s great economic growth engine without the periodic crises that punctuated the rise of other major economies such as the U.S.?
Since the 1990s, Chinese economic policy makers have done such a good job of steering around potential potholes that forecasters such as the ones at Macquarie have become extremely wary of predicting trouble. In their note they point to scary historical parallels in the U.S., Taiwan and Japan, but then say that “this very well may play out differently in China” as the government keeps egging on the stock market boom as a way to keep confidence high as other parts of the economy struggle. To which the FT’s David Keohane adds, “we have little argument right now except to warn against an assumption of perfect control by China’s government.”
It’s that assumption of perfect control that is at once the strangest and the scariest thing about China’s economy. It means that one can never put too much weight on market ratios and parallels with other countries, because Chinese officials have learned from economic history and will do what they can to manage their way around trouble. Still, there’s no way a government can be omniscient and adept enough to get that right forever.
The original Tobin’s Q measures the market value of a company’s equity and debt divided by the replacement value of its assets, but as best I can tell it is Equity Q that is used in most discussions of stock market valuation. They’re directionally the same, but not identical -- in the fourth quarter of 2014 Tobin’s Q was 105 percent and Equity Q 110 percent.
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