Margin of Safety!

Central Concept of Investment for the purchase of Common Stocks.

"The danger to investors lies in concentrating their purchases in the upper levels of the market..."

Stocks compared to bonds:

Earnings Yield Coverage Ratio - [EYC Ratio]

EYC Ratio = [ (1/PE10) x 100] / Bond Rate

2.0 plus: Safe for large lump sums & DCA

1.5 plus: Safe for DCA

1.49 or less: Mid-Point - Hold stocks and purchase bonds.

1.00 or less: Sell stocks - rebalance portfolio - Re-think stock/bond allocation.

Current EYC Ratio: 0.87

As of 03-1-14

PE10 as report by Multpl.com

Bond Rate is the Moody's Seasoned Aaa Corporate bond rate as reported by the St. Louis Federal Reserve.

DCA is Dollar Cost Averaging.

Earnings Yield Explained!

Benjamin Graham stated that before purchasing common stocks an investor would need to check to see if the earnings yield is greater than the bond interest by 50%. This is order to maintain a margin of safety which would cushion the investor from unforeseen economic or political events to prevent or minimize a loss.

To arrive at the earnings yield, it is simply expressed as (1 / PE ) x 100 = earnings yield. The earnings however, will need to be adjusted for inflation and cyclically averaged over 10yrs in order not to be lead into a peak earnings trap. This simple PE calculation is done by Multpl.com daily.

Compare that figure to the Moody's Seasoned Aaa corporate bond yield which is easily obtained from the St. Louis Federal Reserve. If you have an earnings premium of over 50% as compared to the bond interest, you are in a good position to add money to your broad based equity mutual fund and have a high probability of a positive outcome.

As soon as the earnings premium is less than 50% stop purchasing equities and shift your DCA dollars to bonds. As Benjamin Graham so elegantly stated: "The danger to investors lies in concentrating their purchases in the upper levels of the market..."

When bonds have an interest premium over the equities earnings yield, it is time to re-balance and/or re-think your stock to bond allocation. This movement between the two can take years; the only problem with this method is that the average investor may simply forget to make the change; or worse and go galloping away purchasing overvalued equities.

Some of you may have done your homework and tested this formula during the 1982 - 2000 bull market and concluded that it didn't work for the 50% earnings premium over bonds was seldom achieved. The investor did not fully participate in the great stock bull market of the 80's and 90's therefore it appears, that the formula doesn't stand up.

Here is the genius of Ben comes into play. the investor would have participated in the bond buying opportunity of a lifetime. This super bull bond market would have been the risk adverse investor dream come true. By purchasing the 30yr Treasury bond outright, and after one year had elapsed sell the bond and replace it with a fresh 30yr Treasury. You are purchasing the bond not for its interest but for the capital appreciation. As report by Jim Bianco of Bianco Research in Chicago, long-term government bonds gained 11.5% on average as compared to the S&P 500 increases of 10.8% during the last 30 years ending October 31, 2011!

Here at DYI we have deep dismay with the Modern Portfolio Theory(MPT) and their conjoined Efficient Market Theory (EFT) crowd (academia); they would have thought that the possibility of bonds out performing common stocks for that long of a time period to be an astronomical long shot at best. With the proliferation of computers and professors who have studied mathematics extensively it seems a shame not to put those skills to work whether they have any benefit. Warren Buffett has stated so directly in the appendix of The Intelligent Investor, "once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail."

To this end, we can state without equivocation, Ben, you are one smart cookie!