Market overview Q4 17: Dreaming

Dreams can have a powerful effect on us, for better and worse. Martin Luther King's famous "I have a dream" speech is a notable example of how a "dream" can inspire individuals to be better versions of themselves and entire communities to become stronger together. Dreams can also be used to describe delusions, however, such as when we don't exercise as good of analysis or judgment as maybe we should—as in, "You must be dreaming!"

There are almost always instances of both types of dreams and often they work in concert. The tech bubble, for instance, was characterized both by the vision that the internet would become a massively beneficial utility and by the delusion that such possibilities would generate almost limitless growth and profitability for its participants. The key for investors is to avoid conflating the two kinds of dreams by identifying the line between the two. By doing this, investors distinguish between investment and speculation and vastly improve their chances of maintaining and growing their hard-earned savings.

In regards to stock performance in 2017, the best characterization might be "dreamlike". The S&P 500 posted handsome total returns of 21.83% for the year in a nearly steady upward climb. Indeed, the market "notched up 14 straight months of gains — the longest run on record" [here] amid an environment of record low and declining volatility. One account [here] noted "VIX closed below 10 more times last year than any others [sic] year in its history, and until today, closed below 10 for the first 5 days of 2018..." Such conditions are creating an environment in which "people [are] having a hard time even imagining how the market could decline." It's as if stocks finally reached cruising altitude and the autopilot was switched on.

Media accounts almost universally attributed the smooth advance to improving economic performance and phrases like "synchronized global recovery" were sprinkled liberally through reviews. One commentary from the Financial Times [here] was representative: "Rarely has the outlook for a new year been as encouraging as it is today ... We expect the synchronized global upswing to continue in 2018."

Those looking for benign causes in justifying their optimism have had plenty of fodder from which to choose, but in each case there is far less than meets the eye. Non-gaap earnings are increasing nicely for the S&P 500, but operating cash flows are just nudging ahead. Lower taxes will provide some short term stimulus but at the longer term cost of higher debt. While sentiment is strong and there are some modest indications of improved consumer spending, it looks like consumers are putting the cart before the horse. As Gluskin Sheff points out, "13-week annualized credit card balances in the U.S. have gone completely vertical in the last few months of 2017" [here].

Further, As David Collum reports in his "Year in Review" [here], "The reported P/Es are not that bad. The high-growth QQQ index, for instance, is sporting a P/E of only 22, and the Russell 2000—the small-cap engine of economic growth—is in the same neighborhood." But as Collum goes on to report, however, there is almost always a more sinister explanation behind optimistic headlines: "Alas, Steve Bregman of Horizon Kinetics notes that the P/E of the QQQ is calculated by rounding all P/Es above 40 down to 40 and assigning a P/E of 40 to all negative P/Es—companies losing money, aka Money Pits ... In the scientific community, we call such adjustments 'fraud.' Bregman pools the market caps and earnings to give a more honest analysis, which gently nudges the QQQ P/E to 87. In short, Wall Street is 'making shit up'."