Via Matt Yglesias, another example of why I have a hard time taking economists seriously, talking about a measure of stock prices:
[T]he “Q” ratio [is] the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.
This is accompanied by a graph that is, basically, the right half of this plot:
(There are a few more years added, showing a steady decline to a current value around 0.5. The longer graph was recommended as a more complete picture by one of Yglesias’s commenters.)
You could interpret this graph a lot of ways, but “the historical natural mean is 1.0” is not one of them. The value has passed 1.0 exactly four times in the last century, and two of them clearly precede massive crashes (in the 1920’s, and today). You might claim that this is a function with a mean value around 0.6 or 0.7 and occasional large upward excursions, but attempting to claim that this is naturally near 1.0 is just farcical.
This isn’t science. This is literary criticism with graphs.
two of them clearly precede massive crashes (in the 1920’s, and today)
Make that three. The first excursion above 1.0 appears to end in the Panic of 1907.
Hey, literary criticism is more scientific than this voodoo crap!
another example of why I have a hard time taking economists seriously
It’s not fair to attribute this to economists. Because of the large amounts of money involved, the investment industry attracts all sorts of people. Most have no academic economics background, and some of those who do are considered by those in academia to have wacky and unjustifiable views. Anybody can write a sales pitch explaining why you should let them invest your money, and success comes from sounding convincing, not from being the best investor, and certainly not from having the best academic reputation. The Q ratio stuff is stupid, but I imagine it sounds impressively technical and reassuring to unsophisticated investors. Unfortunately, unsophisticated investors are a far bigger market than sophisticated investors.
So this is ultimately about as fair as blaming physicists every time someone sends out a press release saying their new company is going to exploit zero-point energy.
P.S. I’m not even an economist; I just work in an office next to one. 🙂
Two of my undergraduate roommates earned Ph.Ds in economics (Amherst and New Mexico), and they have made similar comments (laments, actually, to me) about the lack of numeracy in economics training and the blatant misuse of much that is there.
I teach statistics; I like to believe (based on recent projects) that even my beginning students would know that the above graph doesn’t show what it is claimed to show. Sad.
One a side point: I have no proof of its historical accuracy, but I saw this in two different courses in graduate school. The quote is attributed to Eisenhower. “I’d love to be able to
fill my cabinet with one-armed economists, so I would never again have to hear one of them begin a sentence with ‘On the other hand…’ ”
I don’t care how many arms they have, the world would be a better place if most economists were smushed tightly into cabinets.
While I’m not an economist, it should be a bit below one, because there are always one-time cost barriers to market entry in the real world, not to mention the unavoidable information costs which economists always neglect.
might want to think about your unscientific statement about the unscientificness of literary criticism
Detroit automakers are massively undervalued compared to their replacement value. If you were to replace them, would you put them back? Most large concerns are inefficient and obsolescent. Q~0.6 is not unrealistic.
http://www.americanrhetoric.com/MovieSpeeches/moviespeechwallstreet.html
Gekko: “Teldar Paper, Mr. Cromwell, Teldar Paper has 33 different vice presidents, each earning over 200 thousand dollars a year. Now, I have spent the last two months analyzing what all these guys do, and I still can’t figure it out.”
telephone anyone? I thought science was about taking arguments in context from their sources rather than parroting a secondary source to make a sweeping generalization about a discipline you obviously know little about.
You are quotemining a comment on an article by Bill Gross of Pimco, who is not an economist, but is one of the most thoughtful and successful investors around. The whole piece is an argument that stocks are not cheap. He never states that the average of the chart is 1.0, he states the ratio should converge to 1.0. The argument is that a stock is cheap if it is trading at below the replacement cost of its assets. Environments where the ratio is below 1.0 correlate with a pessimistic view of the economy (and the early 50s, coming of the lows of the depression and the 70s certainly were that). He then goes on to argue that despite stocks appearing cheap from the Q ratio, there are major macroeconomic headwinds that need to be considered.
Economics is not physics, nor even a pure science: it is a social science and therefore does not operate in the same manner. It studies the behavior of individuals not atoms. Atoms dont learn the lastest physical theories and alter their behavior for personal advantage. There is much valid criticism of the discipline’s reliance on an equilibrium model taken from 19th century physics and the naiive use of statistics, but this sort of ignorant ranting discredits the author, not the subject
This reminds me of when I tried to convince my friend that “Novelty theory” is complete nonsense.
You are quotemining a comment on an article by Bill Gross of Pimco, who is not an economist, but is one of the most thoughtful and successful investors around. The whole piece is an argument that stocks are not cheap. He never states that the average of the chart is 1.0, he states the ratio should converge to 1.0.
The point is that it’s blindingly obvious that the figure in question does not, in fact, converge to 1.0, if you look at the data, and not the theoretical ideal. It’s below 0.8 for around 60 of the 100 years shown in the graph, and only above 1.0 for maybe 20 years. The current value of around 0.5 might be below the historical average, but not by all that much.
The inability to recognize that this number has never been converging to 1.0 does not do a great deal to convince me of Gross’s genius. It might make for a good sales pitch, but it’s not even close to reflecting reality.
OK but maybe you should revise your OP as he never argued that the “the historical natural mean is 1.0”. Furthermore this is not a bloody function, it is a historical data series that maps well different economic periods and it is a fact that sub-1 Q’s are correlated with periods of economic disruption. But in context,the whole argument is a recitation of an existing theory that everyone knows is full of holes to simply set up the main argument later in the piece, that the apparant undervaluation of stocks evidenced by the Q ratio is an illusion.
OK but maybe you should revise your OP as he never argued that the “the historical natural mean is 1.0”.
But he argued that “As long as capitalism is a going concern, “Q” should mean revert to 1.0.”
I find this extremely funny. For the period 1960-76 Lindenberg and Ross (Journal of Business 54:1, 1981) calculated a median value of 1.35 for seven industries in the US. The average Tobin q for “Photo equipment” was as high as 3.08 Oddly, the authors state that estimates of q are biased upward because of measurement problems. Indeed, it is very hard to estimate the replacement costs of assets, esp. of intangible assets (like R&D expenditures), so they are usally ignored. The way some idiots interpret the graph is one problem, but the biggest problem IMO is the graph itself. Most of economics is “Voodoo science” because of this one simple fact: the raw data sucks! (if I’m allowed to use that word).
it is a fact that sub-1 Q’s are correlated with periods of economic disruption
This depends on your definition of “economic disruption”, of course, but I don’t see that at all. You will notice that in 1937 (which most people consider to have been part of the Great Depression), the value of Q approached 1, while during Reagan’s second term (which most people consider to have been good times, economically speaking) the value was mainly between 0.4 and 0.6.
And if you read the article closely, you will see that Gross is paraphrasing the argument that the backers of the Q statistic make, before making his case why stocks are actually overvalued, not undervalued. (I don’t know anything else about Q theory, so I have no way of knowing whether Gross is knocking down a straw man or a real argument.) Shame on Matt Yglesias for not making this context clear in his post; he seems to attribute the quoted statement (which he correctly derides as nonsensical) as Gross’ actual thinking.
Q hovers near 1? No shit, Sherlock – I rather suspect that the only way to value a company’s assets (IP, anyone?) is either sheer guesswork or multiplying the stock price by the number of shares issued.
And note, BTW, that the graph is not logarithmic (as it should be). Using a proper graph would make the plot even more precipitous.
I’d argue that he is not even a good capitalist if he thinks it should be 1.0. That argument ignores the leverage of financial markets that regular people call a “loan”. (What we used to be able to get from banks, before they started hoarding their TARP funds.) Loans make it possible to start a company with a fraction of the capital needed to actually replace it, provided you can convince a banker that you can pay him or her back in a few years or ten.
But it is a sound argument if the assets are tangible, something that can be sold for the alleged value of the company. In that case you can invest $50 and get $100 after the company fails. And if you believe that, there is a Ponzi scheme just looking for your money.