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Is it Really (All Quiet on the Western Front)? Or Rubber Bands CAPEs and other Superhero Amenities

It has been some time since we revisited Erich Maria Remarque’s WWI tale, powerfully delivered in the book and subsequent film,  All Quiet on the Western Front.  The novel was first published in November and December, 1928 in the German newspaper Vossische Zeitung and in book form in late January, 1929.

As you will recall, the tale of Paul Bäumer is one that describes in painful detail the listless monotony of war, its incredulous march that builds an impending sense of death and doom; one that leaves our character and many of his colleagues fearful, despondent and ultimately un-incorporable into civilian life.  In the end, it remains a philosophical text that asks the useful question, how important is the death of any single soldier or person?

This kind of question is one the policy makers, capital allocators and prognosticators of all types are beginning to wonder out loud, in various forms and formats.


  • Did the Fed miss its chance to normalize?


  • Are we now going to live in the “Zero Bound” range forever?


  • Does one man or woman’s employment gains matter when the society as a whole appears to be whooping it up (oddly not unlike right after WW I –which of course lead to WWII  –  but I digress)?


The answer to these and other important questions are the kinds inquiring minds want to know.

Remember in the end, our tragic hero Paul Bäumer is killed on an extraordinarily quiet day in 1918; a day that might draw parallels to the flash of 2011 or perhaps the head-fake-no-taper of Sept 18, 2013.  The numerical symmetry is there.  Let’s hope the outcome is different.



Here’s how things stacked have stacked up Month-To-Date in October.



If you are building anything with lumber on planet earth, things got 10% more expensive this month.  This seems unsurprising to us as the former brakes that were jammed on the housing market prior to the mid-September Federal Reserve meeting have been swapped out for a gas pedal with a brick strapped to it for good measure.  Of course it important to remember how the story ends in most cars that have bricks secured to gas pedals and people inside of them.


In other news, risk assets, as expressed by small and mid-cap US based stocks, continue to scream higher sending our forward earnings numbers up (yet again this year), while at the same time levering up the Schiller CAPE numbers.  Time will tell which one is more accurate.


The final set of moves worth noting is the 10+ bps move lower in the US Ten Year.  This was accompanied by some highly correlated moves on the upside amongst equities and the VIX.  Strange bedfellows?  We think not.


On rubber bands

We believe that the rather fantastic snap back in equity prices last week reflects more confidence in continued easy monetary policy, rather that it being reflective of any real fundamental improvement in the outlook for corporate earnings.  Indeed, the quality of earnings, which we sometimes use this space to cover, has been increasingly poor.

We discussed this last week with Pimm Fox and Carol Massar on Bloomberg Radio.

It is important investors understand that corporate earnings are very much like a rubber band.  Not only do they display a tremendous amount of flexibility they have a very curious capacity to snap in ways that seemly befuddle.  But befuddled, investors should not be matching up retail sales, credit expansion and job creation give you a sense of how and why corporate earnings seem to keep expanding.


The current state of corporate earnings is just one of those scenarios.


But what makes up those earnings?  In the US – its retail sales.  We got a look at that landscape this morning:

At the moment, the quality of earnings has been deteriorating for three straight quarters.  The reasons vary from lowered guidance due to a pull back in CAPEX in China, decreasing top line growth that suggests a tired and moderately stretched US consumer (not surprised given the state of labor markets), and the ever present shift from bricks to clicks.  But here is the most disconcerting issue – most neatly pointed our by our pal Steve Blitz at ITG.

 When you look at real economic activity and you match it up with Equity multiple expansion, it’s tough to see how the price expansion doesn’t snap back much like the afore mentioned rubber band.




As we wind down the month, it’s worth taking a moment with one of our three US based Nobel Laureates – Robert Schiller.  A longer piece on the relationship between the three winners of this year’s Skirowski Prize is forthcoming, for now I want to finish up with our focus on earnings because we are in the middle of an earnings season. Oh yeah, and earnings matter.


Bob’s work matters because it gives us a different tool with which to analyze and understand corporate earnings.  In fact, we think it is best described as a model that allows for context.  Forward quarter over quarter guidance is just this side of useless when looking to understanding the current health of a company from a historical perspective.


Schiller’s model suggests that investors look back at real earnings (v. Forward guidance) and do so over a ten-year time frame.  This allows the numbers to get “smooth” by eliminating one good quarter and hopefully the irrational exuberance that comes along with such happy events.


Here is a current look at the CAPE valuations of the S&P 500.



With corporate earnings sitting at or near all time highs and with the CAPE readings well into the 20s, serious investors must now explore the asymmetrical nature of returns at such similarly situated previous points in history.  The short answer is that something has to give.  The question is what gives?



With corporate profit quality declining, equity price expansion not commensurate with what we are seeing in the real economy and CAPE valuations rising, we believe that this equity market cycle has a higher than normal capacity to end in tears.  Not all markets will be treated the same on the sell off and how the sell off gets produced also matters to where and when investors will be effected.


Over-leveraged Emerging Markets with large current account deficits?  Did they spend those dollars wisely?  Stable US treasuries – will they face the music of political dysfunction?  Is Europe really turning the corner on growth or are we witnessing a false positive, yet again, in the Greek tragedy that lured one bank too many to the Sirens.


2014 is make or break.  We may have already broken.


-Lincoln S. Ellis


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