The Q Ratio, or Tobin’s Q, is a measure often used to grade the health of the market. Specifically, it is the ratio of the market value and replacement or reproduction value of an asset. When discussing publicly traded companies, it is generally approximated by comparing the market value of a company’s stock with its equity book value.

Q. Today’s buzzword is Q ratio… which some people say is flashing a yellow light for the stock market. How’s it work?
A. The Q ratio is a popular way to determine how fairly valued the stock market it. It was devised by Nobel Economist James Tobin and, to boil it down, divides the value of company (or the overall stock market) to the amount of money it would take to replace the assets of the company (or all the companies in the market).

Q. Sounds like a daunting task to calculate that!
A. Well, people work from some numbers helpfully provided by the Fed Reserve flow of funds report, and then adjust according to their own variations. But, overall, using those basic Fed numbers, looking back you see that the average Q ratio is about .7, instead of 1— lots of theories about why exactly that is, but the point is that the average does, historically, tend to mean revert to about .7.

Q. OK, so, what’s the track record, and what’s it telling us now?
A. As an indicator of market tops, pretty darn good over the past century. When it moves over 1, you seem to be in a danger zone… and at least by several people’s calculations, that’s where it is now. But note that its not a timing device: for example, it flashed a warning about the tech bubble way early– its an indicator of risk in the market, but doesn’t attempt to be a trading signal.

Q. So every measure has its detractors… what do Q’s critics say?
A. Essentially that profits, not assets, drive valuations, and therefore Q isn’t so relevant. Another argument is that, especially now, a lot of value is in hard to measure intangibles like intellectual property and brand. Both fair points, but still you’d have to concede there should be some correlation between asset values and equity values.

Q. So what’s your bottom line on the Q ratio?
A. Some impressive studies have shown that Q is one of the very best indicators of a bubble– and since loss avoidance is the biggest single key to long term wealth aggregation, it’s worth paying attention to it. But remember that it’s not a timing signal. So maybe it’s a reason to look at taking a hedged, long-short position to the market right now, like some of the biggest family offices that were at the Bloomberg event earlier this week.