Summary

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

Market participants are currently puzzled by a pressing question: is the bear market over or is there more pain to come for equities? In this article we will aim to answer the question using a lot of fundamental work. To understand if the market 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.

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. 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 insures that the stock is also a driver for the market due to it’s size.

Analyst Price Targets and Statistics

We’ll input these stocks into our new Risk Explorer Screener in order to quickly assess both their fundamental and statistical risk-reward set-up.

Models & Price Targets

S&P Valuation and Summary of Models

Now that we have compiled models and Price Targets for the top 10 market moving stocks, it’s time to combine their risk-reward into a single number that we can use as a proxy for the whole market.

Combined upside: 6.75%

SPY Price Target: $435

Note that these upside targets should be interpreted as a best case scenario. They assume no recession would happen in 2023. Furthermore, our ML models take whatever has happened in the past and project a continuation into the future. The neutral setting of these models is in reality setting a high bar for companies to clear, as the explosive growth from 2021 is still factored in future projections. It will take several more quarters for these models to better align with reality and start being truly “neutral” in their projections.

As such, the $435 Price Target for SPY represents the high-end of the range of potential outcomes one year out, exemplified on the chart below.

The present day Fair Value for SPY is $405, when adjusting for this. We’ll call this Scenario A, that markets are currently priced for.

Note the absence of a downside target. We didn’t just forget to add it to the chart. It’s just that downside doesn’t really work that way. If the economy does not achieve a “soft landing” and there is no “Fed pivot” (or otherwise yields stay elevated), then both EPS, growth and multiples get adjusted downwards at the same time. Combined with a lack of liquidity, courtesy of the Fed’s QT program, downside manifests FAST. Just like the saying goes: stocks take the stairs up and the elevator down.

In a “Soft Landing” shallow recession scenario, SPY would continue its controlled drift lower, as valuations get re-adjusted to the “higher for longer” interest rate regime.

We maintain a 17x $203 Earnings valuation estimate for the S&P500, putting the SPY Price Target for this scenario at $345. We’ll call this scenario B, as it is the most likely alternative to scenario A.

If we get a “hard landing” in the economy, we would need to discount our present day $405 Fair Value estimate by around 25%.

This would put our Price Target for SPY at $303, with a downside that could reach $283 in the worst case. We’ll call this scenario C, which would be a surprise for many.

Takeaway

So which one is it going to be? Scenario A, B, or C presented above? As I’ve repeated many times, our job is not to attempt to make predictions, but to manage risk. In our opinion, the odds are split between scenarios A and B with 45% each, with scenario C being an outlier (10% odds).

Let’s review the facts that we have found in this research piece:

• In an optimistic scenario, equity markets can return about 6.75% from the present day close price; with 1-year treasuries yielding a risk-free 4.89%, it is a mathematical certainty that investors are currently not adequately rewarded for the risk they are exposed to;

• Rising yields will make that comparison even harder to swallow; in the event yields move materially higher from where they are now, price pressures will persist for equities; conversely, a Fed Pivot (lower yields) will “make room” for equity prices to move higher;

• ALL the companies we have modeled are showing balance sheet strain; there is not a single company with improving liquidity metrics vs the 2-year average;

• ALL the companies studied show declining valuation metrics, with the current rally stabilizing the trend for now;

• Absolutely no recession is priced in for 2023; ZERO.

How do we trade this?

For now, pricing in the equity markets suggests scenario A is on the table, with no recession on the horizon. This is in stark contradiction with history, that shows there has never been a period with inflation running above 5% that did not end in a recession. This leads to the highly volatile and apparently bi-polar market environment (amplified by algos and 0dte options, of course) that we see today. However, when viewed through the lens of our scenarios, this behavior actually makes sense.

In Scenario A, we are looking to buy on a pullback / consolidation above the key support area at SPY $390 - $400.

Scenario B presents us with a situation where we would want to buy only at the lower extremes of positioning. Until we get there, we should remain short or flat. In order to pinpoint the BUY area, we’ll need to rely on our Market Internals Overbought / Oversold instrument that has previously identified such entry points.

Scenario C is currently something we are not seriously envisioning at the moment. It is just a theoretical possibility. We’ll deal with it if and when we get there.

And yes, by this logic, it means investors are getting a better deal at SPY $395 (which resides at the low-end of scenario A) than they would get at SPY $380 (the higher-end of scenario B). It’s counterintuitive, as many participants are conditioned to “buy low and sell high”. However, this entirely depends on which environment you are trading in.

Good luck out there! Chime in if you need any help with your strategy!

Andrei Sota