S&P 500 Bottom - Up Valuation and Market Outlook for Q4 2024
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.
2024 Outlook
2024 is shaping up to be a monumental year in politics and capital markets as well. Navigating the financial landscape will be more challenging than ever, with a US Central Bank bent on bringing inflation back to its 2% target and not let it resurface 1970’s style. Market participants are acting to front run the Fed faster than ever, creating wild swings in volatility across asset classes.
There are 2 key factors that will drive returns next year:
A US Economic Recession (or not having a recession at all)
The continuing “Range Trading” regime of capital markets (or the change to “Trend Following”)
As calls for a recession in 2023 have echoed further into Q2 and Q3 of 2024, some investors are rightly asking if the coast is clear and “this time is different”. It shall be apparent soon enough if the Fed has indeed achieved a “soft landing” by reducing inflation without hurting economic growth. The “lag effect” of monetary policy is typically 9 - 12 months. Judging by the time the Fed last raised rates (July 27), the full effects of their rate hike campaign should be apparent starting with the end of April 2024, coinciding with the end of the seasonally strong period for stocks.
Until we get more clarity on the inflation - rate hike - economic growth equation, we expect to remain in a “Range Trading” regime, where asset markets react in a bipolar way to the news cycle. The Fed will probably prop up the market when pessimism is prevalent, and talk a tough talk when things get too “hot” and optimism prevails. Such has been characteristic of 2023, with the latest SPY 10% drawdown and rebound from August to November. Signal Sigma strategies (as well as virtually ALL quant models developed in the modern era) are NOT prepared to adequately handle a true range-trading environment, as there has been no such precedent in the last 30 years. Stocks usually “take the stairs up and the elevator down” - this behavior is ingrained in ALL trend-following models, ours being no exception. In 2023, our models under-performed, as markets basically went nowhere (SPY is still below the all-time-highs of late 2021). We can only monitor this situation and manually correct exposure.
Both of these factors will also answer the question of whether small caps are the best opportunity for investment or a value trap. Currently, the disparity in performance and valuation between the “rest of the market” and the “magnificent 7” (AAPL, MSFT, NVDA, TSLA, META, AMZN, GOOG) is near a record. Part of the reason for the outperformance of the mega-caps is the fear of a coming recession. It is rightfully expected that these highly liquid names would give an investor a degree of protection that small caps simply cannot offer. With a lot of “safety” built into their valuation, mega caps could underperform small caps on a relative basis if we don’t get a recession in 2024. Let’s get one thing straight: small caps have a MUCH higher capital appreciation potential at present valuations than large caps and especially mega caps. The risk of recession is, of course, the reason for small caps being cheap, since an economic downturn would hurt these the most.
With that being said, mega cap names will still impact S&P 500 performance to a large degree, since they are the most heavily weighted in the index. Our article will focus on these names, but in the overall setting of price targets we will take analysts opinions at face value (and a discount) in order to build believable scenarios.
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, combined with Market-Cap and Dollar Transaction Volume. 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 comes as no surprise. The top 10 stocks that matter, along with their weights in the S&P 500, are:
Apple Inc. (AAPL) - 7.36%
Microsoft Corp. (MSFT) - 7.34%
Alphabet Inc. Class C & Class A (GOOG, GOOGL) - 3.94%
Amazon.com Inc (AMZN) - 3.47%
NVIDIA Corporation (NVDA) - 3.26%
Meta Platforms, Inc. Class A (META) - 1.98%
Tesla, Inc. (TSLA) - 1.7%
Eli Lilly and Company (LLY) - 1.25%
Broadcom Inc (AVGO) - 1.08%
Mastercard Inc (MA) - 0.88%
In total, these stocks account for 32.26% of the S&P 500’s weighting. There are also significant companies that could be future contenders for the “top 10” like:
Oracle Corporation (ORCL) - 0.48%
Adobe Systems Incorporated (ADBE) - 0.73%
Bank of America Corp (BAC) - 0.54%
Salesforce.com Inc (CRM) - 0.57%
Netflix Inc (NFLX) - 0.55%
Advanced Micro Devices Inc (AMD) - 0.51%
Intel Corporation (INTC) - 0.49%
Qualcomm Incorporated (QCOM) - 0.38%
The Boeing Company (BA) - 0.32%
Palo Alto Networks Inc (PANW) - 0.21%
But these stocks only account for 4.78% of the overall index weighting. We shall cover the valuation of this second echelon of top tier companies in a future article. But for now, we’ll focus our machine learning models on the top 10.
Analyst Price Targets and Statistics
We’ll input these stocks into a table containing the latest Analyst Price Targets, 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 combined 6.47%, assuming an equal weight distribution. Adjusted for index weighting, the figure is slightly higher, at 6.87%.
However, are those Price Targets realistic? What are the underlying assumptions?
We need to investigate further and create our own models in order to validate these 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 check if models are in agreement.
Models & Price Targets
Apple Inc. (AAPL)
Signal Sigma PT: $191 (Raise from $190)
Analyst PT: $197 (from $200)
Upside: 0%
Rating: HOLD
Assumptions:
6% Revenue Growth
45% Gross Margins
14% OpEx pct Sales
Microsoft Corp. (MSFT)
Signal Sigma PT: $448 (Raise from $392)
Analyst PT: $403
Upside: 20%
Rating: BUY
Assumptions:
11.5% Revenue Growth
72% Gross Margins
23% OpEx pct Sales
Alphabet Inc. Class C (GOOG)
Signal Sigma PT: $150 (Raise from $118)
Analyst PT: $146
Upside: 7.2%
Rating: HOLD
Assumptions:
10.6% Revenue Growth
56% Gross Margins
27% OpEx pct Sales
Amazon.com Inc (AMZN)
Signal Sigma PT: $205
Analyst PT: $172
Upside: 39%
Rating: BUY
Assumptions:
11% Revenue Growth
48% Gross Margins
39% OpEx pct Sales
NVIDIA Corporation (NVDA)
Signal Sigma PT: $570 (Maintained)
Analyst PT: $641
Upside: 17%
Rating: BUY
Assumptions:
34% Revenue Growth
61% Gross Margins
30% OpEx pct Sales
Meta Platforms, Inc. Class A (META)
Signal Sigma PT: $367
Analyst PT: $371
Upside: 7.5%
Rating: BUY
Assumptions:
12% Revenue Growth
80% Gross Margins
44% OpEx pct Sales
Tesla, Inc. (TSLA)
Signal Sigma PT: $224 (lowered from $260)
Analyst PT: $224
Downside: -4%
Rating: HOLD
Assumptions:
15% Revenue Growth
15.7% Gross Margins
8% OpEx pct Sales
Eli Lilly and Company (LLY)
Signal Sigma PT: $705 (upgraded from $650)
Analyst PT: $627
Upside: 18%
Rating: BUY
Assumptions:
14% Revenue Growth
80% Gross Margins
47% OpEx pct Sales
Broadcom Inc (AVGO)
Signal Sigma PT: $872 (from $785)
Analyst PT: $900
Downside: -10%
Rating: BUY
Assumptions:
15% Revenue Growth
70% Gross Margins
17% OpEx pct Sales
Mastercard Inc (MA)
Signal Sigma PT: $437
Analyst PT: $447
Upside: 6.5%
Rating: BUY
Assumptions:
8.6% Revenue Growth
24.3% Gross Margins
16.2% OpEx pct Sales
S&P 500 Valuation and Summary of Models for EoY 2024
Now that we have compiled models and Price Targets for the top market moving stocks, representing over 30% of the S&P 500’s weighting, it’s time to combine their risk-reward 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 (Equal Weight): 10.03%
Combined Upside (Market-Cap Index Weight): 11.83%
SPY Price Target: $508 (assuming Market-Cap Index Weight upside)
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. The first important thing to note is that the price targets displayed above are optimistic.
Analysts are pricing in continued revenue growth
For most companies that we have explored, Revenue Growth has formed a “U” pattern, with sales accelerating in the first 3 quarters of 2023 (TSLA and AVGO being notable exceptions to this). When projecting revenue in 2024 and 2025, in order to meet current analyst estimates, we needed to manually set figures significantly above what our machine learning models would predict (right slide below, dotted lines are projections).
In itself, this is not a problem, since a machine projection simply extrapolates the recent past into the future. And in the recent past, we’ve got 2022, a year which saw revenue growth plunge from the highs achieved post-COVID. However, continued and accelerated revenue growth is achievable only in the absence of a recession in 2024.
For the rest of the S&P 500, with companies not in the top 10, revenue growth is not showing ANY signs of a “U Turn” upwards just yet. Simply, sales growth has normalized to the cycle median (around 5%). The argument for a “tide that lifts all boats” and a reversion to the mean for revenue growth has a glaring issue: we are now situated at that very mean, and there’s no reversion to be had. If we had indeed hit the lower bound of this series (around 0% growth), then the mean reversion argument would have a lot more believability. But we are not there yet.
Recession odds spike to 70% in May 2024
The Federal Reserve Bank of New York releases a study on the probability of a US recession every month. According to the latest release (end of October), the odds of a US recession climbs as high as 70% in May of 2024. This aligns exactly with our timing of the “lag effect” from the last Fed rate hike in July 2023.
It’s going to be difficult for revenue growth to proceed in the way analysts predict if the economy goes into recession. At best, in the case of a shallow recession, our machine learning models are more in line with actual results. If we get a deeper contraction, then even these models will prove to be optimistic.
Market Scenarios
SPY Optimistic Scenario (A) - 30% Probability
The optimistic scenario is the one sell-side analysts currently envision. There is no recession in 2024 and revenue growth continues or accelerates for most companies. In this case, upside for the S&P 500 is solid and would surprise to the upside. Bears will have a very bad time in this scenario, since smaller companies have even more upside than the mega-caps. With a lot of fear currently priced in, spall caps (IWM) will massively outperform SPY and QQQ, with an increase in the 25% to 35% range. Bond prices will slowly increase as well. “Trend following” prevails, as an investment style, since breakouts can be bought.
SPY Price Target: $508 (EoY 2024)
CAGR: 12%
ODDS: 30%
For the chart below, we’ll use $490 / 11% CAGR for our September ‘24 target, leaving the rest $18 as upside for the final quarter (our projection window only goes out so far).
SPY Neutral Scenario (B) - 50% Probability
In a neutral scenario, the “lag effect” finally catches up with the real economy and the financial markets. Growth does not accelerate, but it doesn’t contract meaningfully either. Bulls are disappointed, bears are disappointed and the Fed achieves a soft landing via another year where stocks go mostly nowhere. “Range trading” continues to be the investment style that works, since severe dips can be bought and exuberance can be sold. Upside from current prices exists, but is limited and only materializes in the second half of 2024. Bonds reflect the same range trading regime as stocks, and yields remain elevated.
SPY Price Target: $470 (EoY 2024)
CAGR: 5%
ODDS: 50%
For the chart below, we’ll use $465 / 5% CAGR for our September ‘24 target, leaving the rest $5 as upside for the final quarter (our projection window only goes out so far).
SPY Pessimistic Scenario (C) - 20% Probability
In a pessimistic scenario, growth slows dramatically and even large cap companies can’t quite sustain present valuations. Capital flees the equity market for the safety of bonds. As the Fed fights the recession via lowering interest rates, treasuries become the best performing asset class. Range trading continues to be the investment style that works, as wild swings mislead anyone who attempts to follow a trend. SPY re-tests the $350 - $380 area before finally rebounding to $420 once the Fed intervenes. A new, “real” bull market can finally re-start.
SPY Price Target: $420 (EoY 2024)
CAGR: -3%
ODDS: 20%
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 our opinion, the odds favor a range trading approach and an opportunistic and nimble allocation for 2024.
No scenario is truly pessimistic for bonds. Since yields are expected to have hit their cycle highs, all risk has been virtually priced out of bond principal values. The probability of continued losses in this asset class is very low. As a consequence, bonds will form the bulk of our portfolio in 2024. We’ll also keep an eye on certain “STRONG BUY” companies, for opportunistic trading. And yes, “trading” is the keyword here, as we think the best approach is to buy relative lows and sell relative highs during 2024.
Unfortunately for our automated models, odds do not favor “trend following” as a regime in 2024. We expect Nostromo and Horizon to continue to underperform. Enterprise has a more balanced approach and is less prone to regime change instability, but it won’t do great either.
In any case, the time is ticking for the bear thesis. There have been many voices calling out for a recession in 2023 and, so far, no recession has actually shown up. If a material slowdown fails to arrive until Q2’24, watch out for small-caps! There is a lot of fear currently keeping small cap valuations pinned down. If this fear evaporates, a violent repricing will occur in the space, ripping bears faces off. In certain cases, upside can be as large as 40%. It’s safe to say that small caps are the real winner of Scenario A (optimistic). However, in the event of a recession, small caps may plumb -50% drawdowns before recovering.
Good luck out there! Chime in if you need any help with your strategy! And thank you again for supporting Signal Sigma!
Andrei Sota