S&P 500 Bottom - Up Valuation and Market Outlook for Q3 2025
Summary
It’s not a Stock Market, but a Market of Stocks
Every quarter we 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 the last closing price to the 1-year Price Target will inform us of the risk-reward currently offered by the market. 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
The last time we have compiled this analysis, average valuations for S&P 500 companies were stretched to the upside, hovering around a trailing P/E ratio of 25. Today, valuations have slightly receded, but still remain elevated by historical standards, nearing 24 times Earnings. The forward 12-month P/E ratio for the S&P 500 is 21.0, slightly higher than during our last review (20.5). This P/E ratio is above the 5-year average (19.4) and above the 10-year average (17.9).
While valuations are a poor market timing indicator, it’s still important to pay attention to this multiplier, as it will form the basis of our price target calculation at the end of this article.
“Are we going to get a recession in 2025?” - this is the most pressing question facing investors today. One of the most talked about recession signals is the 2-10 yield curve, especially when it is inverted, as it has been for the past two years (inverted means the yield on the 10-year is less than the 2-year). An inversion reduces the incentives for banks to lend, thus increasing the odds of economic weakness. However, the moment when a yield curve inversion occurs is a recession warning but is not usually timely. Contrarily, it is the the yield curve un-inversion which typically portends a recession is coming within a year or less.
The graph below shows the difference between 10-year and 2-year Treasury yields -- aka the yield curve. The dotted circles indicate the last four instances of the yield curve inverting and subsequently reverting.
In every instance of inversion to un-inversion, a recession occurred afterward. Next to each dotted circle, you will find the number of days from the un-inversion until the onset of the recession, as determined by the NBER. It is important to note that the NBER typically announces recessions after they have begun, assigning retroactive dates. As the yield curve is poised to turn positive sometime in the near future, it triggers a warning signal that is hard to dismiss.
Unsurprisingly, the S&P 500 (and most stocks in general) perform poorly during recessionary periods. For reference, the trough forward P/E during the last four recessions were as follows: 10.1x (Oct 1990), 17.3x (Sept 2001), 8.9x (Nov 2008), and 13.0x (March 2020) -- 12.32 on average. That is a dramatic reduction from today’s 21 figure (-41%).
Despite the stern warning originating from the yield curve un-inversion, company executives don’t seem too worried, at least judging by their propensity to use the term “recession” during earnings calls. Among S&P 500 constituents, only 28 cited the term “recession” during their earnings calls for the second quarter. This number is well below the 5-year average of 83 and the 10-year average of 60. In fact, this quarter marks the second-lowest number of S&P 500 companies citing “recession” on earnings calls for a quarter since Q4 2021 (15).
It should be noted that below average readings are not necessarily bullish indications, as was the case in Q4 2019 and Q4 2021, ahead of major bear markets.
The final major catalyst for the year ahead will be the impact of the Fed’s rate cuts on economic activity. Interest rate traders are now pricing in a 100% probability of a rate cut in September, so it’s important to be aware of historical performance around this milestone.
In the eleven Federal Reserve easing cycles we have tracked since 1970, the S&P 500 has frequently provided positive returns in the twelve months after the first rate cut, showing a median price return of +11.9%. However, the macroeconomic conditions surrounding monetary easing significantly influence the outcomes, which is why results around these policy shifts differ widely.
During periods when interest rate reductions successfully extended economic growth and supported rising corporate earnings, equities generally showed strong performance. Conversely, in instances where monetary easing failed to avert an economic decline, equities have usually experienced major losses in the year following the initiation of rate cuts, as corporate profits faced downward pressure. In other words: it all comes down to EPS Growth.
Shaded areas represent the range of historical performance after the first Fed interest rate cut.
With that in mind, here’s how bonds perform historically 12 months after the first rate cut:
Bloomberg U.S. Aggregate Bond Index performance shown
This lengthy introduction has served the purpose of making us better understand the backdrop against which we are investing today. The US Presidential Election in November is another potential curveball for investors, but it’s impact is more of a short-term supply - demand and psychological issue.
Today, we are concerned with Fundamentals and setting price targets for the year ahead.
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.
We’ve set the screener to account for all relevant factors and the market leadership can be defined as follows:
Apple Inc. (AAPL) - 6.9%
Microsoft Corp (MSFT) - 6.59%
Nvidia Corp (NVDA) - 6.49%
Alphabet Inc. (GOOG) - 3.78%
Amazon.com Inc (AMZN) - 3.44%
Meta Platforms, Inc. Class A (META) - 2.49%
Eli Lilly & Co. (LLY) - 1.62%
Tesla, Inc. (TSLA) - 1.25%
Broadcom Inc. (AVGO) - 1.51%
Costco Wholesale Corp (COST) - 0.83%
These are the top 10 companies that matter today and are responsible for the bulk of index-level price moves.
In total, these stocks account for 34.9% of the S&P 500’s weighting. Becoming familiar with their financial prospects will lead to a much better understanding of the whole market's potential for appreciation or decline.
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.
According to analyst targets, the fundamental capital appreciation potential sits at a whopping +18.42%, assuming equal weighting. Adjusted for index weighting, the figure is significantly higher, at +22.65%. However, looking at the distribution of potential capital gains, the bulk of potential appreciation is concentrated in Tech stocks, especially semiconductor related names (NVDA, AVGO). Removing both from the equation would still imply an upside greater than +14%.
Let’s explore these price targets in detail and understand the underlying assumptions. We will employ the help of our ML models for this task, and set projections to Neutral. We will also consult various other sources in order to glean a better insight into the specifics of every company. As an extra step before assigning a Price Target, we will check with individual sell-side analysts and see if our models are in agreement.
Models & Price Targets
Microsoft Corp. (MSFT)
Signal Sigma PT: $503 (Raised from $483), 16% CAGR
Analyst PT: $505
Upside: ~21%
Rating: BUY
Assumptions:
11% Revenue Growth
70% Gross Margins
25% OpEx pct Sales
23.4 x EBITDA Multiple
Apple Inc. (AAPL)
Signal Sigma PT: $206 (Raised from $171), 5% CAGR
Analyst PT: $250
Downside: -9.19%
Rating: HOLD
Assumptions:
4.0% Revenue Growth
48% Gross Margins
14.5% OpEx pct Sales
24.7 x EBITDA Multiple
NVIDIA Corporation (NVDA)
Signal Sigma PT: $174 (Raised from $135), 50% CAGR
Analyst PT: $155
Upside: ~38%
Rating: BUY
Assumptions:
20% Revenue Growth
70% Gross Margins
10% OpEx pct Sales
65 x EBITDA Multiple
Alphabet Inc. Class C (GOOG)
Signal Sigma PT: $208 (Raised from $193), 20% CAGR
Analyst PT: $210
Upside: ~23%
Rating: BUY
Assumptions:
10.8% Revenue Growth
60% Gross Margins
26% OpEx pct Sales
17.2 x EBITDA Multiple
Amazon.com Inc (AMZN)
Signal Sigma PT: $207 (Maintained), 30% CAGR
Analyst PT: $218
Upside: ~19%
Rating: HOLD
Assumptions:
10% Revenue Growth
20% Gross Margins
8% OpEx pct Sales
21.4 x EBITDA Multiple
Meta Platforms, Inc. Class A (META)
Signal Sigma PT: $622 (Raised from $586), 16% CAGR
Analyst PT: $564
Upside: ~19%
Rating: BUY
Assumptions:
12% Revenue Growth
84% Gross Margins
38% OpEx pct Sales
16 x EBITDA Multiple
Eli Lilly and Company (LLY)
Signal Sigma PT: $1184 (Raised from $913), 23% CAGR
Analyst PT: $1050
Upside: ~23%
Rating: BUY
Assumptions:
15% Revenue Growth
78% Gross Margins
47% OpEx pct Sales
58 x EBITDA Multiple
Tesla, Inc. (TSLA)
Signal Sigma PT: $176 (Lowered from $180), -18% CAGR
Analyst PT: $209
Downside: -18%
Rating: SELL
Assumptions:
19% Revenue Growth
15% Gross Margins
9% OpEx pct Sales
41 x EBITDA Multiple
Broadcom Inc (AVGO)
Signal Sigma PT: $179 (Raised from $141), 25% CAGR
Analyst PT: $194
Upside: ~10%
Rating: BUY
Assumptions:
12.5% Revenue Growth
62% Gross Margins
23% OpEx pct Sales
40 x EBITDA Multiple
Costco Wholesale Corp (COST)
Signal Sigma PT: $976, 20% CAGR
Analyst PT: $925
Upside: ~9%
Rating: BUY
Assumptions:
7% Revenue Growth
13% Gross Margins
9% OpEx pct Sales
1.55 EV/Sales Multiple
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.
Valuations have subsided, EPS and Revenue have increased
Since we last ran this analysis, multiples have generally contracted for a lot of these companies. The clearest example is NVDA, now trading significantly below its median valuation for the past two years, both on an EV / EBITDA basis as well as EV / Sales. This is also a result of EBITDA rising by 165% in the last year and revenue growth reaching 122% in the same period (Q2’23 -> Q2’24). This is an example where a company “grows into” its valuation, and we’ve seen many examples of the same dynamic in our analysis (albeit with lower figures).
Margins are making a comeback
Both Gross and Net Margins have seen a resurgence in 2024 and are now firmly trending toward the record values established in 2021. This comes as a result of diminishing inflation (which previously eroded pricing power of corporations) as well as restructuring efforts across various industries (read: layoffs).
As a result, S&P 500 Earnings per Share have maintained the secular trend and have recovered toward all time highs. This also means that Operating Leverage is improving…
…and that any increase in Revenue Growth will translate into a healthy dose of EPS Growth at the bottom line -- given the much improved margins situation.
A chart that looks somewhat familiar to the one above is the M2 Money Supply (Year on Year Percentage Change). It’s no coincidence that corporate top lines saw a 25% increase in 2021, just as Money Supply also increased by 25% during the same period. More money in the economy leads to sales growth (as well as inflation). Since the Fed plans to significantly lower interest rates, more money should be lent into existence, boosting the M2 figure and company revenues.
If all goes well (and we get a “soft landing”), the increased operating leverage should see top line growth (Sales) translate to the bottom line (EPS) in a very efficient fashion, justifying current valuations.
If EPS growth fails to materialize (or even declines as a result of recessionary conditions) - then it’s a completely different ball game.
S&P 500 Valuation and Summary of Models for Q3 2025 (Base Case)
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: 22.75%
SPY Close Price: $548
SPY 1 Year Price Target: $672, at 21% Compound Annual Growth Rate
Note: the Price Target reflects expectations for autumn (Q3) of 2025
Market Scenarios
SPY Optimistic Scenario (A) - 40% Probability
The optimistic scenario is the one sell-side analysts currently envision. There is no recession in the following 12 months, revenue growth accelerates and translates into significant EPS Growth. CEOs continue to provide optimistic projections into the future, high valuations are maintained, the AI boom brings productivity enhancements across many industry verticals.
2025 S&P 500 Earnings per Share: $280
Valuation Multiple: 24 x
SPY Median Price Target: $672 (Q3 2025)
Price Range (+/- 1 STD): $757 - $592
CAGR: 21%
ODDS: 40%
Is this scenario optimistic? Yes, clearly. Is it crazy? Absolutely not. As the chart shows, the implied 2024 Year End price target is close to 600 for SPY, which almost translates to 6.000 for the S&P 500. Although most major brokerages have lower estimates, Oppenheimer and Evercore ISI come very close to our target.
As far as 2025 is concerned the latest S&P 500 EPS estimates are trending toward $280 for FY2025. Notably, estimates for FY2024 were $270 at the start of 2022, but were subsequently revised lower as the reporting period approached — a common practice among analysts.
Nevertheless, an optimistic $280 EPS multiplied by the current 24 P/E ratio gets us to $6.720. It’s just math.
SPY Neutral Scenario (B) - 30% Probability
In a neutral scenario, growth occurs at a more reasonable (or should we say realistic?) rate. This scenario pits investors against an uncomfortable truth: that stocks are currently priced for perfection and may suffer flat-to-lower performance for the next 12 months. There’s nothing that goes “wrong” in particular - valuations are simply too high and won’t be entirely justified. There is no recession in the following 12 months, as the Fed lowers interest rates fast enough to support ongoing growth.
2025 S&P 500 Earnings per Share: $260
Valuation Multiple: 21
SPY Median Price Target: $546 (Q3 2025)
Price Range (+/- 1 STD): $616 - $482
CAGR: 10%
ODDS: 30%
Note: the assumptions for this scenario are in-line with the 12-year historical median values for the P/E multiple (21). The $260 EPS projection also assumes downward revisions, which are common with Wall Street analysts. This scenario feels slightly pessimistic as far as the implied Year - End 2024 fair value target goes ($521) but there are two institutions in agreement with these assumptions: Morgan Stanely and UBS.
SPY Pessimistic Scenario (C) - 30% Probability
A pessimistic scenario implies an economic recession in the next year. At the moment, it’s hard to project anything other than a “soft” recession, with EPS dropping -10% from 2024 values. For comparison purposes, the COVID pandemic resulted in a -32% decline in EPS in 2020 compared to 2019, and the average P/E ratio for the S&P 500 was 15.3 at the through. We won’t project a global pandemic style event, as that would be too extreme and “alarmist”. Instead, we’ll use some “garden variety” recessionary assumptions.
2025 S&P 500 Earnings per Share: $216 ($240 x 90%)
Valuation Multiple: 19 (-2 standard deviations, for the past decade)
SPY Median Price Target: $410 (Q3 2025)
Price Range (+/- 1 STD): $464 - $379
CAGR: 0%
ODDS: 30%
Note: out of all Wall Street banks, J.P. Morgan’s 4.200 target for year end 2024 most closely aligns with this view.
The 30% probability weighting we have assigned for this scenario is based on multiple studies: J.P. Morgan (35%-45% probability), Goldman Sachs (25% probability), the New York Fed (61% probability, with the caveat that it has been elevated since Jan 2024 and is purely based on the yield curve).
Additionally, a recent BofA Global Fund Manager Survey found that 76% of participants think a “soft landing” is most likely in the next year. This would be the equivalent of the cumulative odds for the first two scenarios that we have presented.
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.
In a single chart, here are the potential outcomes for the S&P 500:
At first glance, such a chart is not really helpful, since it shows a large divergence of potential outcomes. However, our analysis is fully in line with the chart presented at the start of this article related to the performance of stocks after the first rate cut -- which bears repeating now.
The conclusion of our findings is that stocks are poised for a high-risk high-reward outcome in the next year. We need to also bear in mind that the outcomes presented above have different probability weightings assigned to them.
Another observation is that investors attempting to “buy the dip” will have vastly different perceptions of “the dip” depending on which view they undertake. For example, in our most optimistic take (A), the lower trendline of the risk-reward channel sits at $509 (-8.7% from the last close).
However, if the market keeps dipping below that value, it would completely invalidate scenario A, and we would need to start working with scenario B, where “the dip” currently resides at $448 (-19.7% from the last close).
While we like buying stocks on the cheap as much as anyone else, “dip buying” will be a dangerous business going forward, as perceptions of value dramatically shift if prices start to meaningfully decline. During periods of increased volatility, buyers reside ever lower.
In any case, another fascinating conclusion is that we may as well find ourselves in an ongoing bull market trend, fully part of an economic expansion, even if the S&P 500 drops -20% and media outlets start headlining “doom and gloom” day in and day out.
Ultimately, we hold a firm belief that our active risk management solutions will become essential going forward. When the market constantly rises, investing looks easy, as the rising tide lifts all boats and investor’s mistakes are forgiven. When the opposite occurs, that’s when losses mount and mistakes become much more costly and hard to “make up”. Our models attempt to smooth out drawdown periods and maximize bull trends.
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