Vaccine bursts bubble of concern over dot-com level valuations

[NEW YORK] Getting the stock market right in 2020 has required forgetting about almost everything that made 2020 a year to remember.

A deadly virus spreading unabated through the US. A historically brutal recession and plunge in profits. Widespread civil unrest. Political uncertainty that is still not entirely resolved.

On top of it all, equity valuations that hadn't been this rich since the dot-com bubble days.

None of it mattered, at least not for long, to a market that seemed to see through the fog of uncertainty and focus on a recovery in 2021.

The final chapter on this strange year has yet to be written, and markets have a reputation for sometimes doing the opposite of what the consensus expects.

But, at least in the past week, promising test results for a coronavirus vaccine are rewarding investors who kept the faith. The S&P 500 closed at a record on Friday after a second straight weekly gain.

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"Any company that has been bought here recently was being bought on anticipation that at some point down the road we get a grip on the virus, business takes off, and those valuations are then justified," said Randy Frederick, vice-president of trading and derivatives for the Schwab Center for Financial Research.

"We often buy maybe a quarter ahead. Now we've been buying three or four quarters ahead."

That forward focus was on vivid display this week.

Across the US, virus cases soared, records were set for hospitalisations and daily new cases, and several states and cities reimposed some restrictions.

But with Pfizer and BioNTech announcing promising results for their vaccine, the virus developments were not enough to deter bulls who poured a record amount of money into stock funds.

While questions remain about production, distribution, and the capability of the shot itself, investors were quick to dump stay-at-home trades like technology and embrace small caps and banks, stocks that are poised to benefit when the economy recovers.

The tech-heavy Nasdaq 100 dropped more than 1 per cent over the week, while the Russell 2000 Index of small-caps rallied more than 6 per cent to an all-time high. The KBW Bank Index had its best week since June, jumping 11 per cent.

The vaccine announcement has much of Wall Street reconsidering its earnings estimates for 2021, a development which should alleviate some worries over valuations.

At Friday's close, the S&P 500 traded at about 22 times the consensus 2021 earnings estimate of US$165 a share, a figure which assumes roughly 22 per cent profit growth.

Partly because of the vaccine news, JPMorgan Chase & Co strategists led by Dubravko Lakos-Bujas boosted their 2021 profit projection for the S&P 500 by US$8 to US$178 a share. Based on that forecast, the S&P 500's multiple would come down to 20.

"Valuation ultimately is the biggest hurdle going into next year," Mark Freeman, chief investment officer at Socorro Asset Management, said by phone. "That's why the vaccine news is an important step toward validating the market's expectation on that front."

In a year when no one could predict with much confidence what would happen to Americans as the pandemic raged, investors tended to write it off entirely.

Thanks to monetary and fiscal support, stocks have defied this year's falling profits, adding more than US$15 trillion in value since the bear-market trough in March.

The vaccine development means corporate America's earnings power may be greatly under-appreciated, according to Jim Paulsen, chief investment strategist at Leuthold Group.

Even as companies beat third-quarter expectations at a record pace, analysts' 2021 forecasts for S&P 500 earnings have increased only 1 per cent since the end of September.

Mr Paulsen sees the potential for profits to hit as high as US$200 a share. That implies a price-earnings ratio of 17.9, close to the index's average multiple in the past five years.

"Economic growth has come back a lot faster than people thought and stayed a lot firmer," Mr Paulsen said.

"When you take the momentum plus the effect of stimulus plus vaccine discovery, I think growth estimates out there are woefully underestimated for 2021, and that tells me earnings estimates are too."

BLOOMBERG