Summary

It’s not a Stock Market, but a Market of Stocks

Every quarter we like to assess the fundamental state of the market by closely analyzing the most important companies. To understand if the S&P 500 has more upside than downside, we need to define the recent rally leaders, create DCF models for each, and set price targets.

The distance from closing price to Price Target will tell us if there is indeed more upside, or if there is more risk than reward in the current setup. We shall rely on our Machine Learning models and company guidance to generate these models. The aim of this research piece is not necessarily to create accurate models individually, but as a group.

Year Ahead Outlook

Record valuations are becoming prevalent across the equity market, as prices have surged (especially in high growth, large cap stocks) and EPS has lagged. The median P/E ratio for an S&P 500 company now stands at 25.40, a historically high figure, reminiscent of the post-covid run-up in late 2020.

However, in stark contrast to late 2020, the Fed now has an opposite disposition towards the economy, still fighting a late battle against inflation. Interest rates were dropped to 0% in 2020. Right now, they stand at 5.5%, along with an ongoing QT program in full swing. If high valuations could be defensible when paired with 0% rates and low inflation, the same cannot be said about today’s environment.

When accounting for a ton of hype about the promises of A.I. technology and analysts that are pumping up various price targets, we’re left with an investing landscape where true value is hard to come by. Especially when comparing an investment in the stock market to the risk-free 1 year treasury yield of 5%. Can these valuation levels be sustained and is an acceleration of growth right around the corner? Only one way to find out… and that is - put in the work to fundamentally assess the key companies that are driving this market.

Defining Market Leadership

In order for us to focus on the correct companies, we need to find out what individual stocks are leading the market higher. Helping us achieve that goal is the concept of BETA (Y-axis), combined with Market-Cap (X-Axis) and Dollar Transaction Volume (filter). A stock’s beta is calculated using both correlation and covariance; the higher the number, the more that stock is moving with the market. Having a significant Market-Cap and Transaction Volume insures that the stock is also a driver for the market due to its size.

Analyst Price Targets and Statistics

We’ll input these stocks into a table containing the latest Analyst Price Targets (no older than 1 month), calculate the potential capital appreciation (equally weighted) as well as weighted according to index constituency.

Models & Price Targets

General Observations

Before we create the 3 fundamental scenarios for the market (optimistic, neutral and pessimistic), we’d like to cover some observations drawn from working on the models.

Recession gets completely priced out of the stock market - but bonds say otherwise

The rally that started in November 2023 caught many analysts off-guard. Just 3 months ago, the consensus 1-year price target for the S&P 500 stood at around 4.800 (for year-end 2024), as this Barron’s article states:

Barron’s recently canvassed six market strategists and chief investment officers about their market and economic forecasts for 2024. Their average year-end S&P 500 target: 4838, up only 3% from Thursday’s close of 4719. Then again, the benchmark index has rallied 12% just since the start of November. Like this year’s late rally, there is good reason to think that 2024, too, will end with a bang, lifting the stocks well above Wall Street pros’ targets.

- December 15, 2023

We are now 2 months into the new year and 4.800 sits -6.5% below the last close value for the benchmark index. It’s safe to say that the “bang” that Barron’s was mentioning has arrived early. Way too early. The fundamental driver behind the blistering rally in stocks has been two-fold:

• The Fed has been perceived as dovish and risk-asset friendly (at one point in January 2024, 6 rate cuts were being priced in)

• Q4 2023 Earnings Season was a great success in terms of guidance and results (+4% YoY EPS Growth for S&P 500 Companies)

The earnings recession that many investors and analysts were fearing has failed to fully materialize, as corporations managed to reverse the post 2022 trend. Yes, EPS has gone through a period of weakness (Q1’22 - Q2’23), but we’ve just recorded the second quarter in a row of EPS growth.

In other words, the market has been able to climb a “wall of worry” and has shown surprising resilience. As a consequence, price targets have been left in the dust by the actual day-to-day market action. Many analysts started to appear bearish and foolish for maintaining lower targets. Naturally, they had to revise their assumptions to match the ongoing optimism and recession calls flew out the window. As an analyst, you can’t keep calling for a recession that does not arrive and still keep your job. In conclusion, the recession has been completely priced out of the stock market. But what about the bond market?

Using the Yield Curve as a leading indicator, this New York Fed model calculates the probability of a recession in the United States 12 months ahead. This model continues to show an elevated recession probability during the entirety of 2024, culminating with 61% odds of an economic downturn by January 2025.

It is safe to say that the price action in the stock and the bond market is widely divergent at this point. Historically, the bond market has been a highly accurate predictor of economic recessions, as this 4 decade chart shows:

Is this time different? Only time will tell.

One thing is for certain: risks are elevated, especially as returns in the market are exceeding historical performance. During the downturn in October 23, SPY’s 3-year CAGR was ~ 6.8% (around the 7% historical average). Right now, this figure has jumped to 9.5%.

The Archetypal Chart

As we modeled the various influential companies that are part of the S&P 500, a chart pattern has stood out, as it has been repeated in several stocks. We’ll use NVDA to illustrate this pattern:

The pattern consists of the following tell-tale signs:

• The stock appears to be trading near the present day fair value (middle of the trading channel)

• During Q2-Q4 2023 there was a “holding pattern”, creating a baseline level from which price has broken out

• Since the lows recorded in 2022, the compound annual growth rate has been eye-popping and hard to sustain fundamentally going forward

• If we follow the implication of this short term CAGR, the stock would reach a highly improbable price (NVDA would top $1700 by year-end 2024 in this example)

• In order to project a more realistic price channel, the CAGR needs to be “tapered” much lower

Here’s the fundamental underpinning of this price chart, also using NVDA as an example. Pay attention to the projected growth rates past 2024, that dictate the CAGR slope:

Indeed, 2024 is shaping up to be a much better year for corporate top and bottom lines when compared against 2022 and 2023 taken as the baseline (there was a real EPS and revenue growth slowdown). But going forward, growth rates need to be projected much lower, as 2024 becomes the new baseline. Hence the projected CAGR of NVDA sits at 20%, versus the 200% CAGR exhibited from September 2022 to present.

The “second tier” 10 stocks

Modeling the most important 10 stocks did cover about 33% of S&P 500 index weighting, but what about the rest? As we’ve seen, an important discrepancy starts to form between names like MSFT, NVDA, AAPL and everything elese. We’ll briefly cover analyst expectations for the following 10 stocks (7% weight):

The equal weight price appreciation potential is 3.8%, much closer to the weighted average 4.04%. We can conclude that for the rest of S&P 500 companies, there is barely any room for error, as most of their potential upside has been already priced in. We will use these values as a proxy for the rest of the index valuation.

S&P 500 Valuation and Summary of Models for Q1 2025

It’s time to combine the risk-reward for analyzed stocks into a single number that we can use as a proxy for the whole market. This will serve as the basis of our analysis going forward.

Combined Upside: 6.56%

SPY Close Price: $512.85

SPY 1 Year Price Target: $545, at 14% Compound Annual Growth Rate

Note: the Price Target reflects expectations for spring (Q1) of 2025, not year-end 2024

Market Scenarios

SPY Optimistic Scenario (A) - 50% Probability

The optimistic scenario is the one sell-side analysts currently envision. There is no recession in the following 12 months and revenue growth continues to accelerate for most companies.

S&P 500 Earnings per Share: $248

Valuation Multiple: 22 x

SPY Median Price Target: $545 (Q1 2025)

Price Range (+/- 1 STD): $587 - $503

CAGR: 14%

ODDS: 50%

SPY Neutral Scenario (B) - 40% Probability

In a neutral scenario, growth doesn’t quite pan out as expected. Inflation is still an issue and requires the intervention of a more hawkish Fed than currently expected. Continued growth is only experienced by a select handful of companies (that do outperform), but “everything else” not A.I., not mega cap is left in the dust. Consequently, the price target reflected in this scenario is more attuned to the equal weight appreciation potential of studied companies and applies a discount to both expected EPS and valuations.

S&P 500 Earnings per Share: $239

Valuation Multiple: 22

SPY Median Price Target: $525 (Q1 2025)

Price Range (+/- 1 STD): $566 - $485

CAGR: 8%

ODDS: 40%

SPY Pessimistic Scenario (C) - 10% Probability

In a pessimistic scenario, inflation does not cool down, negating a rate cut for the entirety of 2024. As yields rise, valuations suffer and stock price performance is seriously dampened.

S&P 500 Earnings per Share: $230

Valuation Multiple: 20.6

SPY Median Price Target: $473 (Q1 2025)

Price Range (+/- 1 STD): $510 - $437

CAGR: 2%

ODDS: 10%

Conclusions

So which one is it going to be? Scenario A, B, or C presented above? As repeated many times, our job is not to attempt to make predictions, but to manage risk.

Whichever scenario prevails, our framework allows for efficient and clear decision making. As a general rule, we would favor significantly reducing risk exposure in portfolios as SPY moves toward $530. There is no short-term outlook which allows for a higher price than this.

In terms of buying a dip, we see the best buying opportunity after a 5-7% drawdown. This would take SPY to $470 - $490 and would allow for decent upside in the remaining year. With only +6.2% of potential gains even in the best case scenario, it’s hard to argue for stock ownership when a risk-free treasury bond yields 4.94% at the 1 year maturity. As the equity risk premium sits at 4%, an investor needs to be compensated with at least 8.94% returns in order to begin contemplating an investment in stocks. No scenario currently offers this.

Feel free to reach out if you need any help with your portfolio or investing strategy! And thank you again for supporting Signal Sigma!

Andrei Sota