The greater the risk, the more risk management matters. The higher financial asset prices go, the more investors need active management and strategies that manage downside exposure. That’s just common sense. So, then, let’s ask: how risky are the markets today?
THE TWO SIGMA PROBLEM
Over the long term, three of the best indicators of how expensive or cheap stocks look are: the Shiller Price/Earnings ratio, Tobin’s Q ratio and the Market Cap to GDP ratio (also known as the Buffett Index because it’s his favorite yardstick).
Professor Shiller won a Nobel Prize for his improvement to classic price to earnings analyses: instead of dividing the price by just last year’s earnings, his metric divides by the average of the last 10 years’ earnings. This effectively adjusts the ratio for business cycles, reflecting the basic economic truth that earnings revert to the mean, just like every other financial series.
Tobin’s Q ratio simply compares the value of the stock market to its replacement costs, measured by what companies report as the value of their assets. Of course companies are worth more than that number because of goodwill, intellectual property, etc., but the difference should remain relatively constant over time.