Markets at New Highs

Last week, we noted that the market was failing various barometer tests to start the year (Santa Rally and the first 5 days of January) and was trapped in a tight trading range. On Friday, that consolidation process ended, with the S&P 500 decisively breaking out to new all-time highs, following a strong +1.23% advance. This is good news, and the main financial media outlets trumpeted the news enthusiastically:

“Friday’s milestone confirms that the stock market is officially in a bull market that began in October 2022, and not just a bounce within a bear market. The S&P 500 is up more than 35% since that low.” – CNBC

Of course, the headline could have said “Investors break even after 2 years of negative returns”, but being bullish is more fun and keeps the industry alive by stoking animal spirits with a bit of FOMO. These are real psychological considerations that we need to factor in, when looking at our own investment biases. Also, when looking at the chart, the breakout is clear, and serves to “invalidate” our current thesis to a certain degree:

For a bit of perspective, the broad market (iShares Russell 2000 ETF) is not participating in this new bull phase, as most stocks are still down -20% from their peak in November 2021. Even the Equally Weighted S&P500 (RSP) is down -3.3% from the peak in January 3’rd 2022.

Despite all of this, the attainment of new highs for the S&P 500 is definitely encouraging and fundamentals have something to do with it. As we have stated repeatedly in our newsletters, the next important catalyst for the market is Q4 Earnings Season.

Last week, the key earnings report was delivered by Taiwan Semiconductor Manufacturing (TSM), a key supplier for Apple, Qualcomm, AMD, Broadcom and most importantly - NVIDIA (cumulatively they account for over 50% of TSM’s revenue). Good news and upside projections from TSM translate into good news for the semiconductor industry, tech more broadly, and the market-cap weighted S&P 500, where the aforementioned companies make up for 12.5% of index weighting. Analysts from Needham issued this note after TSM’s call:

"Our analysis, based on various modeling points provided by management on the call, shows that TSMC may fully digest all the overbuilt capacity and restore the supply/demand balance by the end of 2024. While this means TSMC's fab utilization rate may still be tracking below its historical average this year, 2025 is shaping up to be a strong year for continued revenue growth and CapEx recovery. We ended up not changing our revenue estimates beyond 1Q24, and are forecasting TSMC's 2024 revenue growth to be slightly above "mid-20s", the upper end of the range that management guided, as we expect TSMC is more likely to beat and raise in an upcycle. We are raising our PT to $133 based on 16x our CY25 EPS estimate." - Charles Shi

Given this outlook, it’s no wonder that the S&P 500 rallied and managed to break out. We need to make a couple of adjustments to our base case assumptions going forward, given this dawning reality. First of all, we’ll adjust the odds of our most likely scenarios:

• Base Case Scenario - SPY Median Price Target $470, 7% CAGR - odds lowered to 40% from 50% previously;

• Alternate “Growth Reacceleration Scenario” - SPY Median Price Target $508, 12% CAGR - odds increased to 40% from 30% previously;

We’ll be working with the Alternate scenario in our charts, to allow for a degree of technical upside (we’ll get into the fundamental assumptions required for this to hold up later in the article). This is how we stand currently:

Near term upside sits at $497 (+3.02% higher), while downside tracks the 50-DMA and the R2 level at $462 (-4.23% lower). The MACD signal looks to be forming a positive crossover, but the overall level of the crossover is still quite high, suggesting there’s not a lot of room for gains. All in all, upside STILL looks limited, even after accounting for the improved outlook.

Let’s take a look at the fundamentals and gain some perspective over what needs to happen in order to sustain these valuation levels. Of course each stock is different, but right now, animal spirits are stirred by advances in A.I. - there’s no better stock to illustrate this theme than the poster child of semiconductor tech, NVDA.

NVDA’s Fundamentals

In Q3 2023, when NVDA was trading at ~$470 we analyzed the company from a fundamental perspective and assigned a median Price Target of $570 / share with a CAGR of 40%. You can find the report here.

Since then, in just 5 months, NVDA has exceeded our Price Target (now trading at $594). The key variable in determining a Price Target for NVDA is correctly projecting top line growth. We determined that an optimistic (but not sci-fi) projection would be 34% sequential YoY growth, taking revenues from $27B in 2022 to $116B in 2027. This represents an amazing compound annual growth rate for this size, but doable nevertheless. Cumulatively it would more than quadruple starting revenues.

Currently, top sell-side analysts have upgraded Price Targets well north of $600, some reaching as high as $700. We can use the Valuation Wizard to “reverse engineer” their price targets into assumptions, and see what goes into Srini Pajjuri’s $700 model for example.

In order to justify that $700 target, the company would need to generate no less than 40% sequential YoY revenue growth for 5 years to $145B. In our humble opinion, this is starting to sound a bit like sci-fi (let alone the 51 EV/EBITDA multiple).

So is NVDA and the tech sector overall a SELL? Well… no, at least not yet. Our analysis framework assigns a median Price Target to any security and allows for a substantial margin of error (or standard deviation) both above and below the said target. This is mainly due to supply and demand dynamics driving the share price in the short term. According to our best guess, NVDA is a sell near $687.

The end of QT

Taking a break from tracking the progress of Earnings Season, we’re also keeping an eye on Fed policy. After all, it was their pivot in December that sparked the huge rally we’ve been witnessing as of late:

In the same period, economic data remained resilient, employment was strong, and financial and credit markets were bullish. However, even given this positive backdrop, analysts from Goldman Sachs projected that the Fed will not only start cutting rates, but also end QT (quantitative tightening).

Why would the Fed take pre-emptive action to support an economy that is already looking strong? Why pivot so rapidly, in just 2 weeks? There has to be a strain in the economy that the Fed is seeing. Otherwise they would not risk stocking inflation in order to resolve an imaginary problem. At least that is the logical course of thought. Which brings us to a bit of history:

In June 2019, the Fed started cutting rates and supplementing liquidity to the repo market, while employment was good and economic growth was stable. At the time, there was no recession in sight, but there were various signals in place (inverted yield curve, NFIB surveys). In 2020, the recession arrived via an “unexpected and unforeseeable event” that turned out to be a global pandemic.

If history has taught us anything, it’s that “unexpected and unforeseeable events” are always to blame for recessions. And they always occur more frequently than one would imagine. And no sell side Price Target projection ever takes the into account.

In any case, BofA recently did a survey of professional investment managers asking them about the biggest driver of equity returns in 2024. Corporate Earnings should have been the top answer, but 52 percent said “The Fed.”

There’s no debating that. Added liquidity in the stock and bond markets, lower interest rates and dovish monetary policy will act as a tailwind for equities and treasuries. Unless there’s an actual recession to combat, case in which stocks usually take a dive. Historically, asset prices and yields decline during initial rate cuts in response to an economic recession or financial “event”.

The Fed is now expected to cut rates in May for the first time. As such, the timeline for a recession to hit is about 2 months out from that point. This means that by July - August, we’ll get a pretty good indication of weather there’ll be a recession or not. Up until that point, equities have plenty of time to grind upwards.

Our Trading Strategy

Considering all of the above, our slightly defensive posturing versus our benchmark is still valid. We are looking for a more significant pullback in the stock market in order to increase risk exposure. There’s no evidence of financial fragility just yet, and it would be premature to speculate otherwise for now.

We don’t know who exactly the Fed is bailing out. This is knowable only after the fact becomes obvious. But we are aware of this potential downside catalyst and it’s the main reason keeping us from going more aggressive on stock exposure right now.

The other reason is that besides tech and semiconductors (+ some pockets of Healthcare), there’s little underlying strength in the broad market. This was and remains a narrow advance.

But bullish technicals and low volatility argue for maintaining the current equity market exposure that we DO have (90% of benchmark). There’s minor adjustments to be made that we’ll cover during Portfolio Rebalancing.

Otherwise, we’ll let earnings roll in and find the best opportunities for mispriced stocks.

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