Why fairly valued stock markets are an opportunity

We have bad news and good news. The bad news is that the world economy is teetering on the brink of what may well be the most damaging slowdown since the second world war. Policymakers around the world – particularly in the inordinately complacent surplus countries – do not begin to understand what this may mean. The good news is that, after an extended period of overvaluation, stock markets are, at last, attractively priced. This should have enticing implications for investors and even for audacious governments.

How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape).

The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.

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