Note from dshort: Here is my monthly update with extrapolated data since the most recent Fed Z.1 report (through Q2). However, I’ll post a new update on December 11th, an hour or two after the Federal Reserve’s noon release of the Q3 Z.1 release.

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Financial Accounts of the United States of the United States, which is released quarterly.

The first chart shows Q Ratio from 1900 to the present. I’ve calculated the ratio since the latest Fed data (through 2014 Q1) based on a subjective process of extrapolating the Z.1 data itself and factoring in the monthly averages of daily closes for the Vanguard Total Market ETF (VTI).

Interpreting the Ratio

The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102, Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 39 (Market Value) divided by Line 36 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that “the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same.”

The average (arithmetic mean) Q Ratio is about 0.68. 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 1.64 — which suggests that the market price was 141% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is approximately 55% below replacement cost. That’s quite a range.