Tobin\'s q theory of investment predicts that a stock market boom is the precurs

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Tobin's q theory of investment predicts that a stock market boom is the precursor of an economic recovery. (Explain with full explainations)

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Tobin's q From Wikipedia, the free encyclopedia Jump to: navigation, search Tobin's q[1] was developed by James Tobin (Tobin 1969) as the ratio between the market value and replacement value of the same physical asset: One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for the newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.[1] Single company Although it is not the direct equivalent of Tobin's q, it has become common practice in the finance literature to calculate the ratio by comparing the market value of a company's stock with its equity book value. The ratio Tobin's q is calculated by dividing the market value of a company by the replacement value of the book equity: Tobin's q = rac{ ext{(Equity Market Value + Liabilities Book Value)}}{ ext{(Equity Book Value + Liabilities Book Value)}} [edit] Aggregate corporations Another use for q is to determine the valuation of the whole market in ratio to the aggregate corporate assets. The formula for this is: q=rac{ ext{value of stock market}}{ ext{corporate net worth}} The following graph is an example of Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1900. Tobin's Q graph.png[2] [edit] Application If the market value reflected solely the recorded assets of a company, Tobin's q would be 1.0. If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. High Tobin's q values encourage companies to invest more in capital because they are "worth" more than the price they paid for them. q = rac{ ext{Market value of installed capital}}{ ext{Replacement cost of capital}} If a company's stock price (which is a measure of the company's capital market value) is $2 and the price of the capital in the current market is $1; the company can issue shares and with the revenue invest in capital. In this case q>1. On the other hand, if Tobin's q is less than 1, the market value is less than the recorded value of the assets of the company. This suggests that the market may be undervaluing the company. John Mihaljevic points out that "no straightforward balancing mechanism exists in the case of low Q ratios, i.e., when the market is valuing an asset below its replacement cost (Q1). In the case of the stock market as a whole, rather than a single firm, the conclusion that assets should be liquidated does not typically apply. A low Q ratio for the entire market does not mean that blanket redeployment of resources across the economy will create value. Instead, when market-wide Q is less than parity, investors are probably being overly pessimistic about future asset returns." Lang and Stulz found out that diversified companies have a lower Q-ratio than focused firms because the market penalizes the value of the firm assets. Tobin's discoveries show us that movements in stock prices will be reflected in changes in consumption and investment, although empirical evidence reveals that his discoveries are not as tight as one would have thought. This is largely because firms do not blindly base fixed investment decisions on movements in the stock price; rather they examine future interest rates and the present value of expected profits. [edit] Other influences on q Tobin's q measures two variables - the current price of capital assets as measured by accountants or statisticians and the market value of equity and bonds - but there are other elements that may affect the value of q, namely: * Market hype and speculation, reflecting, for example, analysts' views of the prospects for companies, or speculation such as bid rumors. * The "intellectual capital" of corporations, that is, the unmeasured contribution of knowledge, goodwill, technology and other intangible assets that a company may have but aren't recorded by accountants. Some companies seek to develop ways to measure intangible assets such as intellectual capital. See balanced scorecard. Tobin's q is said to be influenced by market hype and intangible assets so that we see swings in q around the value of 1. [edit] Tobin's marginal q Tobin's marginal q ,is the ratio of the market value of an additional unit of capital to its replacement cost. [edit] P/B ratio In the case of inflationary time, Q will be lower than P/B ratio, conversely it will be higher than Q.[3] During periods of very high inflation, the book value would not reflect the cost of replacing a firm's assets, since the inflated prices of its assets would not be reflected on its balance sheet. [edit] Criticism Olivier Blanchard, Changyong Rhee and Lawrence Summers found with data of the US economy from the 1920s to the 1990s that "fundamentals" predict investment much better than Tobin's q.[4] What these authors call fundamentals is however the rate of profit, which connects these empirical findings with older ideas of authors such as Wesley Mitchell, or even Karl Marx, that profits are the basic engine of the market economy. Doug Henwood, in his book Wall Street, argues that the q ratio fails to accurately predict investment, as Tobin claims. "The data for Tobin and Brainard’s 1977 paper covers 1960 to 1974, a period for which q seemed to explain investment pretty well," he writes. "But as the chart [see right] shows, things started going away even before the paper was published. While q and investment seemed to move together for the first half of the chart, they part ways almost at the middle; q collapsed during the bearish stock markets of the 1970s, yet investment rose." (p. 145)[5] [edit] Divergence from reality Jonathan Nitzan and Shimshon Bichler, in their book Capital as Power, argue that Tobin's q has not operated according to the dictates of neoclassical theory. Instead of moving in the same direction, as is required by neoclassical theory (since there should be symmetry between capitalization and real assets), the market value of corporate equities and bonds moves in the opposite direction to the current cost of corporate fixed assets. If all markets cleared Tobin's q should normally average around 1, with the market value of corporate equities and bonds moving lock and step with the current cost of corporate fixed assets. But, instead, Nitzan and Bichler explain, Tobin's q has fluctuated wildly with a historical mean of 1.24. Typically neoclassical theory pins the high mean to "intangible assets" such as knowledge, technology, and goodwill since a corporation's balance sheet normally only includes machines and other tangible assets. Neoclassical theory further argues that the fluctuations in Tobin's q are due to 'irrational' bubbles and crashes which can be accurately forecasted by the market value of corporate equities and bonds moving up faster that the cost of corporate fixed assets in a bubble, or dropping faster than the cost of corporate fixed assets in a crash. The data, however, does not support this theory; instead of the changes of capitalization amplifying 'real' assets, they move in exactly the opposite direction (p. 178-181). When corporate assets increase in price, corporate equities and bonds drop, and vice-versa as seen in the graph below titled "U.S. Capital Accumulation and Fixed Assets". This, the authors claim, creates a problem for neoclassical theory and makes the relationship in Tobin's q meaningless.

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