The Q-Ratio and Prozac

There are many ways to look at the stock market. One of these is the Q-Ratio.  There is an interesting article at Advisors Perspective on that factor.  It is worth a look. What does the market sell for versus value.

The idea is that markets are about pricing and pricing is at least partly about people and their emotions.

I found this graph within the article.  It covers a long period and shows the correlation between the Q-Ratio and the Inflation Adjusted S&P 500.  The part that caught my attention is the red exponential regression line.  It is represents the real historic change in fundamental value of all the businesses. If the market is below for a while it must get above for a while to make the average work.  Regression to the mean works both ways. Long regression lines tend to dial out temporary conditions.


You will notice that the market was greatly above the line after 1994 except for a tiny reversal in 2008.  Does that mean the market will move below for a time to make it all work or have things changed and yields will be higher in future?  Could go either way on that guess.

Here are some of the factors to consider:

If price is related to alternative investments then equity investments are expensive should interest rates rise.  The cash flow from a business is worth much less in a 10% interest market than in a 2% interest market.  Part of the last 10 years being buoyant is because the retrenchment of prices has been offset by the attractiveness of cheap money. 

Asset values are relative to the cost of money.

Will rates go up in the future?  Almost certainly yes.  Will corporate earnings and future opportunities increase faster than that?  If yes, then prices are sustainable.  If no, then the price must fall.

Will rate change affect all stocks the same way?  No. 

Will managers, including individuals adapt quickly enough?  Probably not.

When the market becomes unfriendly, managers find stress increasing.  Stress breeds fear.  At one time fear lead to defensive action.  Not so much now. Today, managers can mitigate the stress with chemistry.

Do you think a manager with access to Prozac or similar substances behaves in down markets the same way as managers did before it was available?  Maybe not.  It could be a coincidence but the euphoria after 1992 or so could be partly because of the rise of Prozac.  It was introduced in the late 80s and was selling billions of dollars worth annually by the late 90s.

I have wondered for a long time if the boom in the late 90s was because of the “happiness” drug.   Emotion plays a big part in investment performance.  Maybe there is no objective downside if chemistry denies fear.

Try to be consciously objective about value and prospects for the market.  The Q-Ratio could help you to be objective, Prozac might not.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  866-285-7772

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