Are stocks disconnected from reality? Probably, according to Tobin’s Q, a rather elegant way to assess equity valuations developed by the late Nobel Prize-winning Yale economist James Tobin. Put simply, Tobin’s Q compares the total value of stock prices with the value of underlying assets such as plants, inventory, and equipment (i.e. replacement costs). Add up the value of the equity, then buy all the assets, and see if you have some cash left over. If you do, stocks were overvalued. 

We’ve looked at this on a number of occasions, most recently in January when we noted that the Q ratio was near peaks observed over most of history’s bull markets, and as Bloomberg reports, stocks are now more overvalued than at any time in history with the exception of the tech bubble and the 1929 highs.

Via Bloomberg:

If you sold every share of every company in the U.S. and used the money to buy up all the factories, machines and inventory, you’d have some cash left over. That, in a nutshell, is the math behind a bear case on equities that says prices have outrun reality.

The concept is embodied in a measure known as the Q ratio developed by James Tobin, a Nobel Prize-winning economist at Yale University who died in 2002. According to Tobin’s Q, equities in the U.S. are valued about 10 percent above the cost of replacing their underlying assets — higher than any time other than the Internet bubble and the 1929 peak.

Here’s a look at the chart:

The above should come as absolutely no surprise to regular readers. Indeed, corporate management teams have adopted policies that virtually ensure the value of their equity will far outrun the replacement costs of the underlying assets. 

As we’ve documented exhaustively — in fact, one might argue that it’s been the single most important narrative we’ve pushed this year — companies are taking advantage of record low borrowing costs and voracious demand for corporate bonds by issuing record amounts of debt. The problem: the proceeds aren’t going towards capex (i.e. future growth and productivity) but rather towards buybacks which not only inflate EPS but also management’s equity-linked compensation.