by Archie M. Richards, Jr., CFP^®
January 29, 2001

Ted and Jeri write, "We've been reading about the Q Ratio, which compares the market value of all U.S. stocks with the replacement value of real assets of all U.S. companies. Normally, the market value of stocks is lower than the replacement values of real assets. But now, the market values are greater than the replacement values. The Q ratio has never been higher than in the last year. Some experts say this means a 50 percent decline in prices. Should we sell our stocks?"

Such predictions can be scary, Ted and Jeri. In this case, the inventor of the Q Ratio, James Tobin, was a member of President Kennedy's Council of Economic Advisers. He is a Professor of Economics at Yale and a Nobel Prize winner. How can you go against someone with credentials like that?

Actually, I don't find it hard at all. In 1981, Professor Tobin thought President Reagan's intention to cut government spending and reduce tax rates would prove disastrous. Wrong. He believes that when unemployment gets too low, inflation will inevitably rise. Wrong. He believes that part of the Social Security funds should be invested in stocks by the government. This is a recipe for doubling and tripling government's control over the economy! How wrong can you get?

I'll say this for Mr. Tobin: In 1999, he thought that his Q Ratio did not predict a market crash. Nevertheless, unless a person knows that government's role in an economy should be highly restrained, every prediction he makes is best disregarded.

Don't let the Nobel Prize snow you. If committee members who select the recipients don't know how economies work, the recipients won't either.

Any expert who suggests selling stocks is betting against the long-term uptrend. For example, Barton Biggs, a respected market analyst at Morgan Stanley, recommended the sale of stocks. Among other things, he cited the Q Ratio as evidence that prices were overheated, overvalued, and vulnerable. We've just had a bear market. The prediction was on the mark, right?

Wrong. Biggs said this in 1996, when the S&P 500 was less than 800; it's now 1355. Had you taken his advice, you'd have missed substantial gains.

In the mid-1950s, when the S&P was only 40, some experts said stocks should be avoided until stock dividend rates rose above bond interest rates. Prior to these predictions, dividend rates had indeed been higher than interest rates. But after the predictions, they weren't, and they never were again. If you had taken the advice, you'd have missed generally rising stock prices for forty-five years.

Is the Q Ratio now too high? Not in my opinion. The public's belief that big government solves social and economic problems is dwindling. State legislatures, governors, both houses of Congress, and the Presidency are all shifting more and more toward faith in free markets. The damaging policies that Congress passed during the Johnson Administration often stall in today's legislature. Liberals have increasingly used executive orders, regulatory agencies, and the courts to force through their agenda.

But among elected officials, faith in free markets will continue to strengthen, and all segments of government will eventually fall in line. The changes will make the economy grow faster, reduce volatility and risk, lower inflation, improve the environment, and help the poor most. The impact on the market value of stocks will be stupendous.

The Q Ratio, as mentioned, compares total stock market values with the replacement values of real business assets. Less and less work, you realize, is being done by big-time mechanical brawn. More and more is performed by high tech, which results from brainpower. Mechanical brawn is reflected in the real assets of businesses. Brainpower is not.

Decades hence, physical things may well be constructed by microscopic robots, atom by atom, in seconds. The market value of stocks would not then be modestly higher than the replacement values of real assets. Market values could exceed replacement values by twenty times or more, making the Q Ratio irrelevant.

After adjusting for inflation, stocks over periods of at least ten years not only grow faster than bonds, they lose less. Disregard all experts who suggest selling. Buy stocks and hold. It works.