Q Tip: Stocks Are 50% Overvalued, Expert Says

Andrew Smithers told investors to dump stocks just as the market peaked three years ago. Thirty-five hundred Dow points later, he hasn't changed his tune.

In his book Valuing Wall Street, published in early 2000, the founder of London-based advisory firm Smithers & Co. had some urgent advice for investors: "By far the most important thing you can do with your money is get it out of stocks. What you do with it then is a second-order problem."

It might be easy to suggest this was a lucky call, if not for the q ratio. First discussed by Nobel laureate James Tobin in 1969 and modified by Smithers and co-author Stephen Wright, q is a way to measure the difference between where stock prices are and where they should be. Looking back, it arguably has been the most accurate long-term predictor of market movements.

What does the q ratio -- and Smithers -- tell us about U.S. stocks today? Brace yourself.

Because q measures the value Wall Street assigns to stocks compared with the cost of actually creating those businesses (replacement costs), the proper q ratio in theory would be 1. As of Thursday's close of 868.52, the S&P 500 had a q ratio of 1.50, meaning the index would have to fall about 33.5% to 577 to get to a q of 1. It would have to fall even further to revert to its historical average of 0.65.

According to Smithers, investors still don't grasp how overvalued domestic stocks are. "American investors are still in a bull market, psychologically. They are still trying to figure out how to make the most money, when they should be more interested in not losing it."

Based on his reading of q, coupled with his opinions on the economic malaise and the effectiveness of policymakers here and abroad, Smithers maintains that the most likely return for U.S. stocks over the next five years is very poor.

Investors, especially those with a shorter-time horizon, should be out of the market. "The economic growth rate is below trends, which means falling profits -- it's not that the economy will disappoint, but profits will," Smithers said. "This is not something American investors have taken on board."

Q and Its Critics

To explain how q works, and why some say it's outdated, we must define it. q is the number you get from dividing the total value of the stock market by total corporate net worth, as measured by the Federal Reserve's data on replacement costs. (Smithers & Co.'s Web site has a page that can determine q for you.)

Applying this formula over the past century, q correctly signaled that markets were extremely overvalued in the late 1920s, undervalued in the late 1940s, overvalued in the late 1960s and undervalued in the early 1980s. In the late 1990s, q reached its highest levels ever, signaling to Smithers that the market was 2.5 times overvalued.