"If there weren't luck involved, I would win every time." -Phil Hellmuth, Professional Poker Player
The stock market is a lot like poker. You may have a great hand, however, what begets success is a complicated structure that involves other players.
When it comes to the stock market, a great portfolio of stocks is comprised of valuation versus aggregate value and growth metric risk balanced with an understanding of the current political economic outlook.
There are several unknowns however, such as threats to aggregate growth, industry expansion and specific stocks. As in poker, successful investing can be held with a great hand but success is never guaranteed.
Winning poker players, such as Phil Hellmuth and Phil Ivey, understand the metrics of the game and use both odds and a complex understanding of human nature.
Bluffs are when players overplay low-value hand, which is akin to buying over-priced stocks. High-value hands, such as pocket aces, are played in a manner akin to holding high-value stocks.
Just as in holding the nuts (the best hand) pre-flop, uncontrollable circumstances can always change the nature of the game and as such, the most disciplined player would realize the option of holding or folding may be better than increasing the bet or going all-in.
Achieving Discipline In A Rising Market
The stock market's basic valuation metrics are the price-to-earnings (P/E) ratio as well as projected short-term growth. While momentum always plays a role, disciplined long-term investors place value where value is due and over the years are richly rewarded.
Taking Warren Buffett, for example, the man who said to "Buy America" at the lows of the post-financial crisis bloodbath, while momentum was the market's enemy, value was there and his discipline has been rewarded by exceptional capital gains.
As the market continues to gain value off the 2009 lows, the investment community has been rife with the terms "bubble" and "correction". These fears balance optimism, which is a net benefit to control current pricing in favor of value, however, the current level of pessimism due to a two-day S&P 500 decline of 2.96% is overblown.
The S&P 500 Index, while currently off 3.27% from all-time highs, is trading at a valuation that long-term investors should find very attractive.
Forward Economic Indicators Continue To Strengthen
The U.S. LEI (Leading Economic Index) is a composite of ten forward economic indicators that is produced monthly by the Conference Board. It's a great index to measure, as it has accurately predicted the past two recessions. Before a recession, the indicator will observe a streak of monthly declines. When the index turns upward, it is a precursor of economic growth.
In December 2013, the LEI inched upward once again in a sign of continued economic strength. As noted in the chart below, the Coincident Economic Index, which measures the current economy, also continues to rise.
The Current Bull Market
Along with earnings improvements, from March 2, 2009 to January 23, 2014, the S&P 500 Index price has improved from 797.87 to 1790.29, which is a rise of 992.42 points, or 124.4%.
Due to the steady nature of price appreciation in the current bull market, many naysayers believe that the market must observe a correction.
The same reasoning suggests that if a roulette wheel lands on red six times in a row, then it must land on black next. In actuality, past performance is no indicator of future results.
While this correction fear may turn out to be a self-fulfilling prophesy, at today's prices the market is attractively valued. Rather than give in to current fears, the intelligent investor should heed valuation and stay invested for the long term.
The Current S&P 500 Index Valuation
On January 23, 2014, S&P Capital IQ observed 2014 earnings guidance of $121.09 per share. At the current value of $1790.29, this equates to a P/E ratio of 14.78.
If earnings were expected to decline year-over-year, such a yield might be considered low. According to S&P Capital IQ, however, the market earnings estimate will increase from $107.82 in 2013 to the aforementioned $121.09 in 2014, which is an improvement of 12.3%.
While S&P 500 TTM earnings have stagnated around $100 per share for five of the last six reported quarters (Q2 2012 to Q3 2013), they are set to explode higher over the next five quarters. Improvement in earnings momentum should lead to higher valuations, as markets reflect where they are going, not where they have been.
While many may state that Q4 2013 estimates were below expectations, as of January 23, 2014, nearly 25% of the S&P 500 Index constituents have reported earnings which have been quite impressive considering over half have beat their consensus earnings expectations.
In aggregate, over 75% of reported Q4 2013 earnings have met or exceeded estimates, which is quite good for the market.
Another way evaluating the valuation of the stock market is to flip the P/E ratio and create what is called the earnings yield, which is measured by dividing earnings by price. In terms of the S&P 500, the 2014 expected earnings yield is 6.76%.
In other words, buyers of the current domestic stock market via the S&P 500, which can be purchased through low-cost index funds such as the SPDR S&P 500 ETF (NYSEARCA:SPY), are holding an index of domestic stocks that are expected to yield 6.76%, which is a remarkable 402 basis points premium to the risk-free rate (10-year U.S. Treasury yielding 2.74%).
Historically speaking, when stocks are yielding above the risk-free rate, they are considered undervalued, while yields below the 10-year Treasury rate are considered overvalued.
Over the course of the current bull market, the S&P earnings yield has exceeded the 10-year Treasury yield. The chart below constructs opening quarter Treasury yields from Q2 2009 to Q1 2014, while S&P 500 earnings yields are by dividing forward earnings per share by opening quarter prices.
By subtracting the 10-year Treasury yield from the S&P 500 forward earnings yield, one may find the historical risk premium of the current bull market. By multiplying the difference by 100, the calculation arrives at the basis-point spread, which equates to a .01 percentage difference per basis point.
As the best poker players lose the occasional hand while holding the nuts pre-flop, stock market investors observe the same risk as markets don't always go straight up. Even with improving fundamentals, the market is always at risk of a correction or reversal.
The current market is projected to grow earnings at 12% this year while observing a current forward earnings multiple of just 14.78. This turns into a forward earnings yield of 6.76%, which equates to a risk premium of 403 basis points over the 10-year Treasury bond yield.
Just as a poker player would bet heavy with pocket aces, a low stock market valuation with growing earnings and continued economic expansion is a market the intelligent investor would want exposure to.
While reserve chips may be held in anticipation of a strengthening hand (lower stock prices), not betting on the nuts and awaiting a better hand may result in missed opportunity and the absence of positive real returns. BUY STOCKS