The first chart shows Q Ratio from 1900 to the present. I've calculated the ratio since the latest Fed data (through 2011 Q2) based on a linear extrapolation of the Z.1 data itself.

**Interpreting the Ratio**

The average (arithmetic mean) Q Ratio is about 0.71. In the chart below I've adjusted the Q Ratio to an arithmetic mean of 1 (i.e., divided the ratio data points by the average). This gives a more intuitive sense to the numbers. For example, the all-time Q Ratio high at the peak of the Tech Bubble was 1.82 — which suggests that the market price was 158% above the historic average of replacement cost.

The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57% below replacement cost. That's quite a range.

**Another Means to an End**

Smithers & Co., an investment firm in London, incorporates the Q Ratio in their analysis. In fact, CEO Andrew Smithers and economist Stephen Wright of the University of London coauthored a book on the Q Ratio, Valuing Wall Street. They prefer the geometric mean for standardizing the ratio, which has the effect of weighting the numbers toward the mean. The chart below is adjusted to the geometric mean, which, based on the same data as the two charts above, is 0.65. This analysis makes the Tech Bubble an even more dramatic outlier at 179% above the (geometric) mean.

**Extrapolating Q**

Unfortunately, the Q Ratio isn't a very timely metric. The Flow of Funds data is over two months old when it's released, and three months will pass before the next release. To address this problem, I've been making estimates for the more recent months based on a combination of changes in the VTI (the Vanguard Total Market ETF) price changes and an extrapolation of the Flow of Funds data itself.

**Bottom Line: The Message of Q**

The mean-adjusted charts above indicate that the market remains significantly overvalued by historical standards — by about 42% in the arithmetic-adjusted version and 54% in the geometric-adjusted version. Of course periods of over- and under-valuation can last for many years at a time, so the Q Ratio is not a useful indicator for short-term investment timelines. This metric is more appropriate for formulating expectations for long-term market performance. As we can see in the next chart, the current level of Q has been associated with several market tops in history — the Tech Bubble being the notable exception.

**Footnote on intangibles:**I frequently receive emails asking about the absence of a line item for intangibles in my Q Ratio analysis. On this topic I defer to Andrew Smithers, who touches on the topic in the FAQs on his website:

Does the Existence of Intangible Assets Invalidateq?

No, the evidence is that that the aggregate value of intangibles, if any, does not change over time relative to the replacement value of tangible assets. This is shown by the mean reversion ofqrelative to its average. For an academic analysis see "What DoesqPredict?" by Donald Robertson and Stephen Wright, available on http://www.econ.bbk.ac.uk/faculty/wright.

by: Doug Short

Source: http://advisorperspectives.com/dshort/updates/Q-Ratio-and-Market-Valuation.php

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