World leaders are delighted with the discovery and the roll-out of vaccines against COVID-19. Whilst it is still early days yet for the inoculation programmes, eventually, many people around the world should be able to fight off, and eventually put this awful pandemic behind us.
But that got me thinking. Will the eradication of the deadly pathogen be a good thing or a bad thing for the stock market?
Intuitively, we might conclude that it would be good for shares. After all, the world will gradually be able to recover its lost economic output. People will be able to go back to work. Companies will be able to pick themselves up, dust themselves down and hopefully resume service as normal. That is what is meant by an economic recovery.
But would that necessarily translate to more gains for the stock market? I am not so sure about that.
Market dilemma
The share price, or price per share, can be broken down into the product of two separate components: the price-to-earnings ratio and the earnings per share….
…. the latter is a statement of fact. It is a measure of the total amount of profit that a company makes in relation to the number of shares that it has issued. Subject, of course, to the normal caveats of financial jiggery-pokery.
The price-to-earnings ratio on the other hand, is largely an expression of sentiment. If the market feels confident about a company’s future earnings, then it could be assigned a higher valuation.
The valuation, or the price-to-earnings ratio, is also reflective of interest rates. When prevailing interest rates are low, the P/E ratio can afford to be higher. If interest rates are zero, then the P/E ratio could theoretically go to infinity, and still be deemed cheap.
This is the dilemma that the market must grapple with. As the vaccine goes to work, economic conditions could start to improve. By inference, central banks could feel less inclined to keep interest rates low, which could cause those lofty P/E ratios to start unravelling.
The question for investors is whether the pickup in earnings per share will be enough to counteract the compression in the price-to-earnings ratio. For some companies, it could be a cake-walk. For others, it could be a walk of shame.
It is therefore important to pick our shares carefully. Warren Buffett said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” Never have truer words been said as markets scale and breach all-time highs.
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Disclosure: David Kuo does not own shares in any of the companies mentioned.
