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 significantly stretched to the upside, hovering around a trailing P/E ratio of 24.14. Today, valuations have slightly increased, and remain elevated by historical standards, at 24.59 times Earnings. The forward 12-month P/E ratio for the S&P 500 is 22.3, higher than during our last review (21). This P/E ratio is above the 5-year average (19.7) and above the 10-year average (18.1).

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 into a recession in 2025?” - this was the most pressing question facing investors 3 months ago, when we last analyzed the market from a macro perspective. It seems like the answer to that question is a resounding “NO!”. As the following chart attests, economists polled by the Wall Street Journal have steadily given up worrying about a coming recession.

The years of “unwarranted bearishness” have passed, without a clear recession actually taking hold across all sectors of the economy at once. While some may argue about “rolling recessions” during the last couple of years, it’s becoming increasingly clear that a general economic slowdown (or outright crash) is yesterday’s problem.

In that case… what is today’s most pressing problem facing investors? It certainly seems that there is… no problem at all. According to the latest Consumer Confidence survey, retail investors belief that the stock market prices will increase is at record highs.

This highly unusual optimism is reflected in record inflows into US equity ETFs and mutual funds. Another way to put it is that consumers have never been more interested in buying stocks.

And, of course, optimism isn’t limited to retail investors. It turns out that (at market extremes), professional investors are also equally bullish or bearish. Large asset managers are currently as “fully invested” as they have ever been.

The largest issue facing investors today may as well be that “everyone is already all-in”. Who’s the marginal buyer pushing prices higher if everyone is already fully allocated? Even some of Wall Street’s most notorious bearish analysts have turned bullish during the last quarter (Mike Wilson most notably). An old investing adage says that “Stocks like to climb a wall of worry.” This encapsulates the idea that stock markets often rise despite widespread concerns or uncertainties.

In other words, it’s precisely because these worries and uncertainties are mispriced that allows asset prices to rise, as they resolve themselves into “better than feared” outcomes.

What about situations when the “wall of worry” is missing? What if there are no fears and only optimism?

In that case, we would argue the markets enter a self-perpetuating speculation stage. The “greater fool theory” starts to work. Investors buy assets not because they are fundamentally undervalued but because they believe someone else will pay more in the future, regardless of the asset's actual worth. This behavior perpetuates price increases, which become decoupled from the asset's intrinsic value. Eventually, the supply of "greater fools" runs out, leading to sharp price declines when participants stop buying or attempt to sell simultaneously.

Our analysis today reveals that we are approaching this stage.

This introduction helps us better appreciate the backdrop against which we are investing presently. Three months ago, we were exceptionally bullish (compared to everyone else) and set a 2025 $6.720 Price Target for the S&P 500 — implying a $6.000 year-end 2024 target. At the time, this was among the highest price targets compared to Wall Street Analysts. Take a look at the table below, published last quarter. Only one institution (Evercore ISI) matched our year-end prediction:

Mainstream analysts (and market prices) have since caught up with our previous optimism. As of today, the S&P 500 closed at 6.090 just 17 trading days away from year-end, proving our projection correct in the near term. Let’s sum up the most current S&P 500 2025 outlook recently released by major Wall Street watchers:

• Ed Yardeni, Yardeni Associates: 7,000

• Deutsche Bank: 7,000

• Bank of Montreal: 6,700

• UBS: 6,600

• Evercore ISI: 6,600

• RBC: 6,600

• Wells Fargo: 6,500 — 6,700

• CFRA: 6,585

• Morgan Stanley: 6,500 — (with a 7,400 bull case)

The mean Price Target is 6.687, implying a +9.8% upside form current prices. It’s also reasonably close to our own 6.720 prediction from last quarter.

Here’s the twist: according to our bottom-up research, we will have to downgrade our 2025 price target and come more in line with Wells Fargo and Morgan Stanley in terms of the base-case number. Let’s explore why.

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 S&P 500 due to its weighting.

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.

More Downgrades than Upgrades

This time around, downgrades to Price Targets have been more meaningful than upgrades. Take NVIDIA, for example. For at least the past 4 quarters, we have continually raised the Price Target at every interval. Usually, our targets have landed at the upper end of analyst projections and have proven accurate.

Today, our NVDA Price Target was lowered from $174 (last quarter) to $170. While this does not appear meaningful, and still leaves plenty of upside for investors (+19%), the trend of continual upgrades was broken. This was caused by a slowdown in Revenue Growth and some margins jitteriness. Given that our analysis employs machine learning projections to fundamental metrics, the models are momentum based (applied at the Income Statement level, not at the Stock Price level). A single quarter of slowdown lowers the projection for the next 5 years.

The same dynamic has impacted many other stocks, some more than others.

Earnings Will Matter

Q3 2024 was not bad by any stretch of the imagination, but it was far from stellar (at least when compared to expectations). Average earnings growth was just +5.8% during the quarter. The Trailing Twelve Months S&P 500 EPS is now $195.93 and it’s expected to reach $209.83 by the end of the year, when including Q4. Is this enough to justify a +28% year-to-date rally in SPY?

In our view, the market has massively front run the expected earnings growth. Or, in other words, there is a LOT of earnings growth currently priced in.

Consider that at the time of writing, the bottom-up EPS estimate for the S&P 500 (which reflects an aggregation of the median EPS estimates for CY 2025 for all of the companies in the index) is $275.24. If this projection holds true, going from $210 in 2024 to $275 in EPS would mark a +30% growth rate, which would indeed justify the rally in the benchmark index this year. However, what are the odds of that prognosis coming true? For example, in March 2023, S&P Global predicted that 2024 earnings would grow by 13% for the year. In reality, earnings grew by just 9%.

Over the past 25 years (1999 – 2023), the average difference between the bottom-up EPS estimate at the beginning of the year (December 31) and the final EPS number for that same year has been 6.3%. In other words, industry analysts on average have overestimated the final EPS number by 6.3% one year in advance. If we apply this discount to $275, we get a final value of $257 (or 22% actual growth).

Valuations Can’t Go Much Higher

The final argument that we’ll need to see some impressive earnings growth actually occur in order to get the overall market trading higher is that there’s little room for valuations to expand. Currently, the average S&P 500 P/E ratio is around 24.59. There’s another +8.8% upside to 26.7, where the 2 standard deviation lies for the current cycle. It’s hard to imagine the market getting there on disappointing EPS growth.

The word “disappointing” becomes very tricky in this context, when applied to expectations of +30%. Consider that earnings cannot outgrow the economy over the long term, as corporate earnings are derived from economic activity. The data supports this concept. Historically, GDP growth has closely correlated with corporate earnings growth. Data from the Federal Reserve shows that, since 1948, a 1% increase in real GDP growth has translated to roughly a 6% increase in S&P 500 earnings on average.

According to the latest estimates, the U.S. Economy is expected to grow by +2.5% in 2025, translating to a +15% earnings growth for S&P 500 companies. If +15% is the final growth rate, this would put 2025 S&P 500 EPS at $241, far below the currently expected $275, but within a reasonable margin to the error-adjusted $257 figure that we got earlier.

S&P 500 Valuation and Summary of Models for Q4 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: +5.22%

SPY Close Price: $607.81

SPY 1 Year Price Target: $640, at 19% Compound Annual Growth Rate

Note: the Price Target reflects expectations for year-end 2025

Market Scenarios

SPY Optimistic Scenario (A) - 30% Probability

The optimistic scenario is the one Ed Yardeni and several other sell-side analysts currently envision. Growth happens at an accelerated pace and momentum carries on, as higher prices beget higher prices. The market may get frothy, but growth is too strong for anyone to really care about valuations.

2025 S&P 500 Earnings per Share: $275

Valuation Multiple: 26x

S&P 500 Median Price Target: $7.150 (Year-End 2025)

SPY Price Target: $715

Upside: +17.6%

ODDS: 30%

SPY Neutral Scenario (B) - 50% Probability

In a neutral scenario, growth occurs at a more reasonable (or should we say realistic?) rate. We’re taking into account the over-estimation margin of error that analysts have historically projected. Instead of $275 EPS, we’ll use $257 error-adjusted EPS and a valuation multiple closer to the present-day (25x).

2025 S&P 500 Earnings per Share: $257

Valuation Multiple: 25x

S&P 500 Median Price Target: 6.425 (Year-End 2025)

SPY Price Target: $642

Upside: +5.63%

ODDS: 50%

SPY Pessimistic Scenario (C) - 20% Probability

A pessimistic scenario implies underwhelming economic growth. And by “underwhelming” we don’t mean it in an absolute context, but in a “relative to expectations” context. A +15% EPS growth would be underwhelming in this case, but otherwise perfectly aligned with historical data.

2025 S&P 500 Earnings per Share: $241

Valuation Multiple: 23.5x (still elevated)

S&P 500 Median Price Target: $5.663

SPY Price Target: $560

Downside: -7.87%

ODDS: 20%

Conclusions

The market is getting stretched, both on technical and fundamental metrics. While the downside in the pessimistic scenario is mild, the upside in the base case scenario is also uninspiring. Sure, if we get strong EPS growth and continuing optimism, it is feasible that the S&P 500 will put in another year of +10% returns. But the conditions for such a rally to occur are getting improbable.

It’s much more likely we’ll get a decent correction at some point in 2025 that will allow us to achieve better results from actively managing our exposure. Normally, we would be looking for around 8% upside to our base-case price target in order to remain fully invested (4% risk free rate + 4% equity risk premium). That implies a $592 or below “buy-the-dip” target for SPY.

From current prices, a decline to $592 implies -2.47% downside, which is not enough to justify actively selling. However, once that potential downside reaches -5%, it would be enough for us to start selling into strength. As such a medium-term “Take Profits Target” is $623 or above.

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