Q&A with IFA: Do Fundamentals Tell Us When Stocks Are Overpriced?


Question: In their book Valuing Wall Street published in early 2000, Andrew Smithers and Stephen Wright claim that the Q ratio popularized by Nobel laureate James Tobin reliably identifies periods of extreme overvaluation and undervaluation in stock prices. Can investors use this indicator to implement a successful market timing strategy?

Note: The question above was originally addressed in DFA’s Fama/French Forum. Professors Fama and French gave this brief and to-the-point response:

“This proposition has been tested in several papers, and the answer is no. The market-to-book ratio for the market (a proxy for q) shows some ability to predict stock returns during the 1930s, but not thereafter.”

We will begin our elaboration on their response by explaining Tobin’s Q ratio. For a single company, the Q ratio is calculated as the market value of a company’s assets divided by the replacement value of those assets. To buy a company’s assets free-and-clear, you would have to not only buy all of its stock, you would also have to buy all of its debt. In reality, nobody would buy a company that way, so a common proxy for Tobin’s Q is the price to book value ratio, as stated by Fama and French above.

Based on the Vanguard Total Stock Market Index Fund, the current price-to-book ratio of the U.S. stock market is 2.3 as of 7/31/2014 according to For Japanese stocks, using the iShares Japan Large-Cap exchange-traded fund as a proxy, the price-to-book ratio is 1.1. This does not mean that the Japanese market is “undervalued” relative to the U.S. market. Fama and French’s statement that investors should avoid market timing based on price-to-book ratios implies that they should avoid country-picking as well.

In actuality, the more common behavior of investors is to pursue the countries that have enjoyed good recent returns, meaning that in this instance they would prefer the U.S. market which has trounced the Japanese market in every year since 2008 (including year-to-date 7/31/2014). It is important to recall the underlying principle that all markets price companies based on their forward looking prospects, and while the markets appear to be saying that the future is brighter for American companies, it is not equivalent to saying that they can be expected to deliver a higher rate of return to their investors. This is the stumbling block that trips up even highly experienced investors. Since Japanese companies now appear to have a greater degree of value risk, they may have a higher expected return, but by no means is it a free lunch.

This question is very similar to a question that we recently addressed on price-to-earnings and price-to-dividends. The New York Times of 8/16/2014 featured a column by Nobel laureate Robert Shiller discussing his cyclically adjusted price-to-earnings (CAPE) ratio reaching a level it has only seen in three other instances—1929, 2000, and 2007, just before a severe bear market. Professor Shiller offers up some possible explanations for the “mystery of lofty stock market elevations” but is not completely satisfied with any of them. He concludes with a note of pessimism, “I suspect that the real answers lie largely in the realm of sociology and social psychology — in phenomena like irrational exuberance, which, eventually, has always faded before. If the mood changes again, stock market investments may disappoint us.”

As we noted in the article referenced above, a Vanguard study1 found that Shiller’s CAPE ratio explained 43% of subsequent returns, and while this is better than all the other indicators they evaluated, even Professor Shiller is quick to point out that it should not be used as a basis for a market timing strategy.

Indeed, if there is such a thing as a “successful market timing strategy” as mentioned in the original question above, then to quote John Bogle, “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.”


1Davis, Joseph, Charles Thomas, and Roger Aliaga-Díaz, 2012. Forecasting Stock Returns: What Signals Matter, and What Do They Say Now? Valley Forge, Pa.: The Vanguard Group.