Introduction

The last several years have been a fairly wild ride for market participants. From covid growth shocks, to money printing, to transitory inflation … then not transitory inflation, rapid rate hikes and now AI disruption, the last 5 years offer a crash course into all of the mechanisms that drive valuation and equity pricing.

So in this post we are going to do our best to explore the following topics:

Where we are
Inputs into Valuation
What’s been driving Markets
Where we go from here

1. Where we are

To get started… here is a fun plot of the S&P from 2020 - Present

SPY: data source Yahoo Finance

As you can see, as of the time of writing we are back to all time highs.

What’s not to love about that?!

But the S&P 500 is only as good as its components, so to get a better idea of what’s going on we can take a look under the hood.

I don’t really know how useful it would be to show every component’s individual return (certainly my computer won’t love it). So let’s do some better descriptive analysis.

Basically what we want to do is get a sense of broad market participation in the overall success of the index return. Because the S&P 500 is a market weighted index it will obviously be skewed to its largest components so it’s good to understand how all stocks within the index are performing.

One way to gauge broad index strength and overall market strength is to see the number of stocks at their 52 week high.

Another way to think about this is the number of stocks in the index making all time highs. Now this is going to be choppy if we just look at it on a daily basis so instead we will look at this stat as a 200 day moving average.

Percentage of Stocks At 52 week high in S&P 500 index

As you can see we started 2023 with the lowest number of stocks making new highs in the index since the great recession.

Since then we’ve started to trend upwards, however, we are still below average.

Another point of significance is that while the S&P 500 has reached new all time highs, the percentage of companies also making all time highs is much lower when compared to the last time the market was at these levels in 2021.

Next we will look at the number of stocks outperforming the S&P 500. Again to smooth it we look at the 200 day average.

Percentage of Stocks in the S&P 500 outperforming the S&P 500 index

As you might expect this indicator hovers around 50% , however, we are currently below 35%. This means around 65% of the S&P 500 constituents are under-performing the index. This is the lowest level recorded over this period and much lower than the previous 50%+ of participants outperforming in the peak of 2021.

Finally, we will look at the percentage of stocks advancing within the index. We do this by looking at the percentage of stocks with a rolling 252 day return above 0. We then also go ahead and smooth this average as well.

Percentage of stocks advancing in the S&P 500 index

This figure tells a similar story as the Percentage of Stocks Above 52 week high in S&P 500 index above. The index is starting to trend up throughout 2023, and we are above 50% again but still below average and significantly below where we were at the last all time high.

So we have the market at all time highs but without any significant broad strength… so what’s going on?

One highly talked about narrative in this market is the Magnificent Seven (M7). If you are unfamiliar, the M7 are the large dominant tech names that effectively drove the market performance through 2023. These names are:

Apple (AAPL)
Alphabet (GOOG)
Amazon (AMZN)
Meta (FB)
Microsoft (MSFT)
Nvidia (NVDA)
Tesla (TSLA)

To get a sense for what the M7 look like we will look at 3 portfolios.

The first is an equal weighted M7 portfolio, the next is an equal weighted S&P 500 minus the M7, and the third is the regular S&P 500.

Equal Weight Magnificent Seven vs Equal Weight S&P 500 minus M7 vs S&P 500

As you can see the M7 portfolio has dominated the other two returning over 250% since 2020. This does include a massive draw-down in 2022, but also a major rally last year.

As for the other two portfolios… well they roughly performed the same.

This is mainly because while in 2023 the Equal Weight S&P 500 minus M7 lagged significantly, it also outperformed the other portfolios in 2022.

Let’s take a look below:

You can see that in 2020 and 2021 the EW M7 portfolio dominates but the rest of the market Equal Weighted Index Minus M7 isn’t too far off from the normal S&P 500 return. This is because these rallies in general were broad and many stocks participated in these years.

In 2022 the big tech names got hit very hard and the M7 portfolio tanks over 45% at the same time the EW Minus M7 out performs the normal index by almost 800 basis points.

In 2023 we then saw the resurgence of these tech names with the M7 portfolio basically matching its post covid “free money era” return. The rest of the market, however, lagged the normal S&P 500 significantly, under-performing by 13%. This underscores how much the general Index return was driven by just these 7 names and how much narrower the 2023 rally was compared to 2020 and 2021.

We are only a few short weeks into 2024 but so far the story is the same … if not worse. The M7 are trail blazing and the S&P 500 is up again. But remove these stocks and the rest of the market is actually down 1.4%.

2. Inputs to Valuation

Before we can talk about the narratives that drive valuation we first need to understand the inputs into valuation.

Valuing most things is actually quite simple. At a high level there are only three variables needed:

A cash flow (CF)
An understanding of how that cash flow grows over time (g), and
An appropriate discount rate (r) to determine the present value of those future cash flows

Of course like anything, the devil is in the details.

The easier it is to predict these variables the easier an asset is to value and therefore the less volatility in its price. Equities are generally more volatile assets because all of these variables are hard for investors to agree upon.

That being said, by using some basic assumptions what we can do is derive the current implied inputs into valuation and then break down price into its components.

For cash flows (CF) we will proxy using:

The Trailing Twelve Month Earnings Per Share.

For the discount rate / Cost of Equity (r) we will use CAPM model with the following assumption:

The 10 year treasury rate as our risk free rate
5% Equity risk premium
A five year rolling beta vs S&P 500

Finally for our growth assumption (g):

We calculate the implied growth rate from a standard constant growth model (Gordon Growth model) using the market price and the other two variables above

With these variables, we can now break up the valuation into three parts to determine what is driving the share price.

Part 1: Effects from Changes in Cash Flows:

Think of this as the Price of the stock if it was solely valued based on its TTM EPS assuming no growth and no changes to interest rates (We fix the interest rate to Jan 1 2021).

Part 2: Effects from Changes in Interest Rates:

This is the difference between the no growth value of the TTM EPS but with a dynamic Cost of Equity (mainly driven by changes in interest rates) and Part 1.

Note: technically we are not controlling for changes in beta in this exercise as generally they are smaller and over the last 5 years changes in interest rate dynamics have been the main factor driving cost of equity

Part 3: Effects from Changes in Growth Expectations:

This is the difference between the actual stock price and the no growth value of the TTM EPS with dynamic cost of equity

As you can see the sum of these three parts will equal the current stock price, but will also give us some intuition into what’s driving the current price.

Let’s take a look at some examples:

Apple deconstructed

For this exercise we start Jan 4th 2021 (due to data availability), with the risk free rate at 93 bps.

You can see with AAPL the share price appreciation in 2021 came primarily from growing EPS. Earnings growth is the most sustainable way to grow share price because it actually reflects real value the company is creating today.

Through 2022 AAPLs share price falls almost $50 from $175 to $125. You can see that this is equally due to both falling growth expectations and also rising interest rates. Over this period contributions from earnings were stagnant.

Through 2023 contribution from earnings again did not move, and the effects from interest rates were not as significant, meaning that the stock price appreciation was all attributable to future growth expectations.

How about for some other names

Microsoft deconstructed

You can see the similarities here as well.

2021 price action was led by both earnings growth and future growth expectations.

In 2022 those growth expectations completely reversed but with the added effect of higher rates.

By 2023 earnings grew modestly but the overwhelming majority of price appreciation can be attributed to booming future growth expectations.

Here are some others.

Alphabet deconstructed

Again, a very similar story.

The Magnificent 7 all follow this similar pattern so it would be good to look at some other “real economy” stocks as well to see what has been driving those.

McDonalds deconstructed

MCD is a great example because this stock has performed very well over the last three years, but you can see that its growth contribution hasn’t really changed, while almost 100 dollars worth of value has been subtracted because of rising rates.

So how did it still manage to grow its stock price? Easy… consistent and steady earnings growth.

Coca-Cola deconstructed

KO is another interesting example because you can see how much of its value is simply derived from its no growth earnings steady state discount rate. You can also see that the fall in value from the effects of rising rates are almost perfectly offset by higher value from growth assumptions.

I don’t think this necessarily means people believe coke is going to grow so much more than it did in 2021, more so that its discount rate shouldn’t be as sensitive to interest rates as we made it for the purposes of this exercise.

Proctor and Gamble is another stock like this with a similar story.

P&G deconstructed

Finally we will look at Home Depot whose decomp looks oddly similar to a tech stock but for different reasons.

Home Depot deconstructed

For HD 2021 was a great year with 1/3 of its growth coming from EPS and another 2/3 from increased growth expectations.

In 2022 its stock price fell almost $100 which was almost entirely due to higher rates.

2023 was a choppy year with the stock eventually finishing up based primarily on rising growth expectations even in light of falling EPS.

You can start to see how deconstructing a stock’s valuation can help in understanding its current price.

Obviously it’s still important to have some intuition behind the individual company and the overall market condition, but nonetheless once you know the valuation factor driving performance it’s easier to understand the macro narratives driving performance.

Let’s take a look at that in the next section.

3. What’s Driving Markets

For the last two years the major overarching narratives for markets have been:

2022 Inflation and Rate Hikes
2023 AI Revolution

Let’s start in 2022. First off you might have noticed in the deconstructions above that most of the effects from rising rates followed the same pattern. And if you follow markets close enough you might have noticed that it looks very similar to the long bond return.

We can proxy the return using the TLT, which is the long duration ETF.

TLT return 2021 - Present

We will use the TLT to proxy the interest rate narrative but we still need something to proxy the AI narrative.

For this we are going to use Google Search Trends for: “Artificial Intelligence”.

Google Search Trends for AI

Next we can add these two figures together with the overall S&P 500 returns. For easier comparison all figures have been scaled.

Narratives

From this simple illustration it’s easy to see how equity market performance in 2022 was driven primarily by rising interest rates.

And in 2023 the explosion of AI interest helped drive market performance. This also helps explain why the market recovery in 2023 was not a “broad” recovery. It was confined to names that could benefit from this narrative… namely the “Magnificent 7”.

Interestingly though it seems the market is about 2 months behind the general search trends.

4. Where we go from here

Markets are future looking, and a lot of that “future” shows up in the growth component of our model.

But once we have an idea of the major narratives and what is driving a stock’s price we can use this to see how different scenarios could affect markets moving forward.

For instance, we know the current positive price action is largely driven by the AI narrative in the form of increased growth expectations. So any changes to that narrative will have a meaningful impact on the market.

Furthermore, rates are still at historically high levels. This is likely suppressing other names in the index who don’t have the same growth narratives. But what this does mean is that any potential rate easing could help broaden the market rally and help in strengthening participation.

The intent of this post isn’t to speculate on individual stock performance in the coming year but combining the decomposition and major market narratives helps illustrate how a stock is being priced and therefore its potential risks.

For instance, take AAPL. Assuming rates don’t change too drastically they need to find a way to either grow EPS this year or keep convincing the market that the AI growth narrative is strong. If they can’t, then it’s likely we could see volatility in the stock given how much value is dependent on that growth story.

McDonald’s on the other hand isn’t dependent on the same future growth story, and they can continue to perform well by continuing to deliver on earnings. A company like MD, as we saw, also has a lot to gain from a falling rate environment. Now you could make the case that a falling rate environment may also indicate slower real economy growth which may be offset in the earnings component, but even if that is the case (in my opinion) it still has value that could be unlocked in that environment.

Conclusion

Our valuation decomp was not overly sophisticated, but still useful to understand both what drives value and where value is being derived for a given stock.

It’s important to understand that this exercise wasn’t about trying to find a “fair value” for any individual stock but instead to understand how market participants are allocating the value that is represented in the current price.

We were also able to explore how different macro narratives manifest themselves into market prices and even take a look at the current market rally breadth.

Markets move fast, and even faster today. Narratives will come and go and there will always be unknown unknowns, but having an understanding of the components of valuation will always be in style.

What drives markets: an exploration of Valuations and Narratives

Jonathon Barbaro, CFA