Why the Earnings Yield of AAA Bonds is Better than Graham Number

In My Investment Philosophy section of this website, I previously stated that the way I’d evaluate if an index fund was overvalued or not was through the Graham Number.

The Graham Number is the maximum multiple (P/E * P/B = 22.5) that Defensive Investors should pay for stocks according to the book The Intelligent Investor.

I started thinking that the Graham Number was too conservative a value due to new facts.

Firstly, investment figures such as John Bogle have been commenting recently that the US stock market is not cheap but definitely not in a bubble, which shocked me considering as of Nov 4th 2014, the Total Market Index [1] is deemed significantly overvalued at 124.9%, and the Shiller P/E ratio [2] is 26.4 (59% higher than historic median).

Secondly, Jae Jun from Old School Value pointed out that the modern day equivalent to the Graham Number “could mean something like staying away from stocks with a PE above 25 and P/B greater than 3.

Thirdly, Kiran Dhanwada from Quest for Value mentioned that Benjamin Graham derived the P/E should be 15 value from the AAA bond yield back then, which was around 7.5%.

Which forced me to come to the conclusion that how I value whether index funds are overvalued or not should be more reactive to the current market environment rather than a valuation formula created decades ago. Using the Graham Number would generate decent results, but I want to optimize my results better.

As a result I think the modern day equivalent to the Graham Number would be the maximum multiple a Defensive Investor should pay is the Earnings Yield of AAA grade Bonds, which is 35.84 [3] as of Nov 4th 2014. The reason I still include P/B is because it acts as a measure for margin of safety in terms of balance sheet, so if the margin of safety is below 100% then it should be compensated by a lower P/E valuation. The reason why P/B’s function as margin of safety is needed is because AAA grade Bonds are almost risk-free, so index funds (or stocks for that matter) should not only at least match the earnings yield of AAA grade Bonds but also provide a certain degree of margin of safety to compensate fluctuating earnings yield or the inefficient re-investment of earnings (earnings not distributed as dividends almost never 100% convert to book value due to all kinds of inefficiencies).

Footnotes

[1] Total Market Index is US GNP / Total US Stock Market Cap. One of Warren Buffett’s favorite method of measuring if the stock market is overvalued or not

[2] Shiller P/E ratio is calculated by using S&P 500’s inflation adjusted earnings in the past 10 years

[3] The highest yielding AAA grade Bond I could buy in USD/HKD as of Nov 4th 2014 was the US Treasury Bonds maturing at 15 May 2038 which had a yield to maturity of 2.79%. The reason I only value USD/HKD bonds is because I deal mostly in HKD, and since HKD is pegged to USD, buying USD bonds that have higher yields than HKD bonds would produce minimal currency risk.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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