Do You Know About The Q Ratio?

Tomorrow (25 September 2013) the Federal Reserve will release the Flow Of Funds Account statistical release for the second quarter of 2013. You may expect to see stories about the release although they will not refer to it specifically. Instead they will talk about “The Q Ratio” and how it is foretelling a significant reduction in the stock market value as measured by major indices.

They could be right too. When the Q ratio is more than 40% or so higher than its arithmetic mean, there tends to be a sell off of the market. 1907, 1929, 1969, 2000 for example. When the ratio reaches a 40% over average high, it has never failed to sell off.

It looks like this:


You can find the entire paper here.

But there is a problem. It is retrospective and it is not responsive in the short run. The Q ratio is clearly a valid predictor but it does not produce short term trading knowledge. It was over the 50% threshold for the 6 years before 2000. I suppose if it predicted the current state well enough traders would use it to drive prices almost immediately and the peaks would never occur. In the markets, anything that works in the short run is used immediately and as soon as the use occurs, the indicator stops working.

Nonetheless, it is worth appreciating and for long term investors it may change your equity mix or emphasis. Maybe to other markets.

There is nothing quite on point for developing economies but an acquaintance of mine, Varouj Aivazian, and others studied a similar question several years ago. Their conclusion, “Our findings suggest that although some of the insights from modern finance theory are portable across countries, much remains to be done to understand the impact of different institutional features on capital structure choices.” The Journal of Finance, Volume 56, Issue 1, pages 87–130, February 2001

In simple terms, it might not work where you are looking. Be cautious.

Markets are far too complex to include a timing element in the predictive aspects of a certain statistic or ratio. Collectively though indicators can help you and you should be aware of them. You do not want to panic, but if you must, do it before the others.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. | Twitter @DonShaughnessy | Follow by email at moneyFYI

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