David A.

Rosenberg July 27, 2009

Chief Economist & Strategist Economics Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

MARKET THOUGHTS
IN THIS ISSUE
The Dow is coming off its best weekly performance since March 2000, and if
memory serves us correctly, that month was marking the beginning of the end of • Market thoughts; what’s
the great bull market at that time. While the bear market rally has been of 1930 lacking in this runup in
proportions, from our lens, that is what it remains and what is lacking in this equity prices are: i)
extremely flashy runup in equity prices are: (i) leadership, (ii) quality, and (iii) leadership, ii) quality, and
iii) volume
volume. There were some very useful statistics in Barron’s (despite the fact that
the headline in the ‘The Trader’ column is Why the Rally Should Keep Rolling … • We believe that corporate
for Now): bonds are better suited in
an L-shaped economic
environment
• The 50 smallest stocks have rebounded 17.2% from their nearby July 10th
lows, outperforming the largest 50 stocks by 750 basis points. • Financials lagging …

• The 50 most shorted stocks have rallied 17.6%, outperforming the 50 least • … But not the consumer
shorted stocks by 880 basis points (over the same time frame). • Confidence sags
• The 50 stocks with the lowest analyst ratings have outperformed the 50 with • The new frugality is
the highest ratings by 380 basis points. fashionable
• 85% of the market has already broken above their 50-day moving averages, • What’s happening with
which in some sense highlights an overbought market, but the other three revenues?
factoids still attest to a low-quality rally, which is best left for traders and • Big week ahead for the
speculators. As tempting as it is to jump in, history is replete with examples of bond market
these sorts of short-covering rallies ending very quickly and with no advance • Not giving credit, even
notice from analysts, strategists or economists for that matter. when it’s due

Let’s put aside the conventional wisdom that the stock market puts in its • Another reason to be
fundamental bottom 3-6 months ahead of the recession ending; it actually bullish on emerging Asia
bottoms ahead of the economic recovery. That was the lesson of 2002 —
recessions can end, but without a recovery there can be no sustainable bull
market, though hopes can certainly bring on bouts of euphoric behaviour as we
saw in the opening months of 2002 when the Nasdaq surged 45% and as we
are seeing currently in the major averages. Japan is another great example. Its
economy was out of recession 80% of the time in the 1990s and yet the lack of
any sustainable recovery was largely behind its secular bear market. For a great
reality check on the situation, have a read of Henry Kaufman’s piece on page 37
of Barron’s (A Long Road to Recovery). To wit:

“Some experts also expect the economy to get a boost from business inventory
restocking. Maybe so, but most likely as a one-time event. Firms take on
inventory if demand rises, if they expect higher prices and if they expect
bottlenecks in the supply chain. But excess capacity is high, and there are no
bottlenecks.”

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Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net
worth private clients, we are dedicated to meeting the needs of our clients by delivering strong, risk-adjusted returns together with the highest
level of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports, visit www.gluskinsheff.com
July 27, 2009 – BREAKFAST WITH DAVE

We also believe that the current edition of BusinessWeek is a must-read — “Some experts also
there were lots of good stuff in there this weekend, some of it following in Mr. expect the economy to
Kaufman’s footsteps (page 14 — A Second Half Recovery Could be Fleeting). get a boost from
To wit: business inventory
restocking. Maybe so,
“Will the upturn last? The question arises because the early stage of the but most likely as a one-
recovery is going to be production-led, not demand-led ... to keep the time event.”
production rebound — and the recovery — going into 2010, overall spending
will have to pick up, and that’s the big uncertainty given the headwinds facing
consumers.”

There is no doubt that inventories have been pared back over the past four
quarters at a record rate, and that the ISM customer inventory index is running
at extremely tight levels. That said, the NFIB inventory plan index remains very
weak, so what we have contributing to GDP in the third quarter is a
mathematical boost to the economy from a lower rate of destocking; much of
this in the auto sector. To actually move towards a sustainable inventory cycle,
businesses will have to see final sales revive. What businesses have done is
essentially recognize that the secular credit expansion has moved into reverse
and the process of deleveraging in the consumer and financial sectors is
ongoing. So, what companies have done in their re-assessments is to re-align
their output schedules, order books and staffing requirements in the context
that there will be a whole lot less credit to support any given level of
production in the future.

What is very likely going to be missing going forward is the consumer because
while it is the “back end” of the economy that helps bring recessions to an end
as inventory withdrawal subsides, it is the “front end” that causes the
expansion to endure — in normal cycles, that is. Historically, consumers end
up adding 3.5 percentage points to real GDP growth in the first year of an
economic renewal. As the economic editorial in BusinessWeek puts it, “this
time, that’s most likely impossible.”

Indeed, any student of the 2000-2003 cycle knows that in the year after that
downturn, the consumer offered little help — contributing barely more than
one percentage point to GDP growth, which was unprecedented and the
cyclically sensitive spending segments exerted not one iota of positive
contribution. The difference is that this 2007-2009 cycle was double the
asset deflation and triple the job loss and coupled with a credit collapse,
which means that it is going to take even longer for the consumer to come
back this time around; the view that we have more stimulus this time around
really misses the point. The government is merely substituting for the
dramatic withdrawal in private sector spending and unless the Obama team
manages to implement fiscal package after fiscal package, with the obvious
distorting impact on the economy, the risk that the end of the recession only
manages to bring on a prolonged period of stagnation is non-trivial and is not
priced into the stock market at current valuation levels.

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As we explain below, corporate bonds, while cyclical as well, are better suited
for that sort of L-shaped economic environment. We believe that
corporate bonds are
Watch what the consumer does now that the fiscal stimulus is over for the better suited for an
time being. Year-to-date, total personal disposable income has risen at a L-shaped economic
10.8% annual rate due to Uncle Sam’s generosity; however, wages and recovery
salaries (60% of the income pie) have declined at a record 3.1% pace. We
realize that there is a lot of hype surrounding the ‘cash for clunkers’, which is
a nice gimmick but only with transitory effects. Besides, just how many
vehicles on the road today don’t get at least 18 miles per gallon; this is the
eligibility criteria — Jed Clampett’s jalopy! — See Clunkers Rebate Drives Car
Sales. The chatter is that we are going to see motor vehicle sales improve to
10 million units (annualized) in July. Whoopee. The program is going to keep
sales near 25-year lows.

What is important to focus on here is the ‘new normal’. The ‘new normal’
nearly a decade ago was that 0% financing would bring in 20 million in sales
(and think of all the sales that were brought forward). Today’s ‘new normal’ is
doing everything Washington can do to get to 10 million units. Has it dawned
on them, or anyone else, that since 2000, the number of vehicles sold (net of
replacement) rose nearly 30 million, doubling the 15 million increase in the
number of licensed drivers? The over saturation of the auto market is
unwinding, and this process will very likely take years.

While we are less enamored with the equity market as a whole, primarily the
commodity-short U.S. averages, volatility does offer significant opportunities
from a trading standpoint. For a perspective on this, have a look at Old-
Fashioned Stock Picking Back in Style on page C2 of the WSJ. For the risk
involved, we prefer to express our views in the corporate bond market. Unlike
the stock market, which has de facto priced in a 40-50% earnings surge in
2010, there is no such hurdle or high-hope in the corporate bond market,
which is still largely priced for a deep recession — a GDP contraction of 1-2%
going forward and the unemployment rate heading towards 11-12%.

Insofar as the economy does not relapse to such an extent, there is a

significant cushion embedded in the pricing of the corporate bond market this
time, even after the impressive rally — from Armageddon levels, mind you —
earlier this year. While the S&P 500 was certainly priced for bad news at the
March lows, with an 11x P/E multiple and a 3½% dividend yield at the time, it
can hardly be said that it was priced for nearly the disaster that Baa corporate
bonds were when spreads were hovering near levels (over 600bps) not seen
since the early 1930s. Have a look at Bonds Look to steal Stocks’ Thunder on
page C1 of today’s WSJ. The article cites analysis showing that default rates
could hit 14% and high-yield bonds, as an example, could still generate
significant returns — and our former colleague, the legendary Marty Fridson, is
quoted in the article as saying that returns could “reach the mid-teens over
the next year” so long as the recession doesn’t deepen (unlike equities, the
downturn doesn’t have to end — just not get any worse).

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July 27, 2009 – BREAKFAST WITH DAVE

FINANCIALS LAGGING
Everyone we talk to believes that a new bull market began in March when the The sectors that will
White House and the Fed gave the large banks blanket guarantees for their likely lead the market in
survival and Congress basically instructed FASB to switch back to ‘mark-to- the future will be the
model’ accounting rules so the financials could show a profit. So the ones at the forefront of
financials had their nice initial pop, but since May 6th, that is nearly three
energy innovation
months now, they have basically done nothing. Not just done nothing, but
have underperformed the market by 650 basis points. Financials do not have
to necessarily lead the pack during a bear market rally, but no fundamental
turning point has occurred with the financials lagging behind as they are
currently. Food for thought.

Many pundits mistake a narrowing in credit spreads with some expectations

that the economy is going to make a convincing shift into expansion mode. All
spreads have done is go from pricing in a depression to pricing in a recession.
Indeed, Baa spreads currently are still above the peaks of most prior
recessionary phases. The credit crunch is far from over, even if we managed
to emerge from the abyss last March. See CIT Beefs Up Tender; Chapter 11
Still Possible on page B3 of the weekend WSJ. And keep in mind that no
regional bank is too big to fail, and they are failing — seven more seized by the
FDIC last week, making it 64 for 2009 thus far.

As an aside, the sectors that will likely lead the market in the future will be the
ones at the forefront of energy innovation (clean-tech). And that means
companies that are working on contracts with DARPA (the research arm of the
Defense Department) may be worth a look — DARPA was the pioneer behind
the development of the Internet, the computer mouse, GPS and others — see
Can The Military Find The Answer to Alternative Energy?

BUT NOT THE CONSUMER

What has led the last leg of this rally has been the most discretionary of the
consumer space: casinos/gaming stocks are up 44% from the mid-July lows;
the homebuilders are up 30%; the automakers are up 28%; advertisers are up
20%; home furnishings are up 18%; hotel/resorts and specialty retailing
stocks are up 15%. It’s only a matter of time before these gains unwind if the
early surveys are correct that this may well go down as the weakest back-to-
school shopping season on record. It is seriously tough to square the bounce-
back in these sectors when you take a look at where consumers are pulling
back the most — discretionary spending items. See Videogame Makers Can’t
Dodge Recession on page B1 of today’s WSJ for just one example. The article
below also serves as a commentary on how spending patterns are changing —
penny-pinching and nickel-and-diming are both in vogue (see Organic Foods
Get on Private-Label Wagon).

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The consumer shift away from vacations towards ‘staycations’ is forcing hotels
The consumer shift away
to cut their room rates at a record pace — have a look at Starwood Offering Up from vacations towards
To 50% Off Some Rooms on page 2B of the USA Today. In addition, the ‘staycations’ is forcing
airlines are now raising their baggage fees to make up for the decline in hotels to cut prices
passenger volumes (there is a take on this on page 1B of the USA Today). It
seems as though as smoking is the only habit that is not dying, and the
tobacco producers are actually raising their prices successfully (see Tobacco
Lights Up on Premium blend on page C10 of today’s WSJ).

A key test for the back-to-school season may be when the kids come back
from camp, and we see the extent of any possible H1N1 virus. All we know is
that there was no shortage of Purell being handed out on Visitor’s Day in
Muskoka yesterday. See When America Sneezes on page 8 of the weekend FT
— this is still not front page news but the threat of a pandemic is gaining
speed, according to the WHO. The Center for Disease Control estimates that
without a successful vaccine, 40% of Americans will catch the virus within the
next two years.

CONFIDENCE SAGS
The final results of the University of Michigan consumer sentiment survey for
July came out on Friday, and a late-month pickup could not prevent
confidence from slipping back to 66.0 from 70.8 in June. We like to look at
the ‘buying conditions’ segment, and it fell to a three-month low of 111 from
121 in June. Homebuying intentions faltered as well to 147 from 157; auto
plans slid to 133 from 139. Income expectations also dropped to 113 from
120; and 50% now see the unemployment rate rising in coming months, up
from 48% in June and 46% in July. Interestingly, opinions about government
policy declined from 96 to 91, a five-month low for the White House and
Congress.

THE NEW FRUGALITY IS FASHIONABLE

We have been writing about the need for the boomers to start putting more of
their money into savings and less into discretionary spending for some time.
And, BusinessWeek ran with an article that may sound as if it is has been said
before (The Incredible Shrinking Boomer Economy on page 27), but there
were some fascinating factoids in the piece (from a McKinsey study):

• The rising savings rates in the boomer population will drain $400 billion out of
consumer spending for the foreseeable future.
• The boomer’s were such an integral part of the spending culture that the
group (79 million) accounted for 47% of national spending before the credit
and real estate bubble burst, yet was responsible for just 7% of national
savings.
• The boomers were responsible for 78% of the spending growth in the
economy from 1995 to 2005.

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• The peak year for spending in the boomer community was 54; whereas for the
generation ahead of them (a thriftier bunch), the peak year was 47. According to S&P, 61%
of the companies that
• The share of boomers aged 54 to 63 who say they are “financially unprepared
have reported are
for retirement” comes to 69%. beating their low-balled
We have said before (repeatedly) that one of the more interesting
profit estimates
demographic trends this cycle is that the only segment of the population that
is gaining employment is the 55+ age cohort. But this has created a gaping
hole in job opportunities for the younger age categories, where jobless rates
are either at or approaching the 20% threshold. What is also fascinating is the
denial over this demographic reality because many college graduates are
holding out for what they believe are going to be lucrative offers — see In
Recession, Optimistic College Graduates Turn Down Jobs on page A10 of the
Sunday NYT:

“Job recruiters may be bypassing university campuses in droves and the

unemployment rate may be at its highest point in decades, but college career
advisers are noticing that many recent graduates do not seem to comprehend
the challenging economic world they have just entered”. Indeed, as one
example of where labour demand is heading, the article cites as an example a
recent job fair at the University of Oregon, where just 55 corporate recruiters
showed up compared to 90 a year ago.

WHAT’S HAPPENING WITH REVENUES?

According to S&P, only 61% of the companies have beaten their low-balled
profit estimates. Yet as we saw in the first quarter, this is being accomplished
via aggressive cost-cutting efforts. With 53% of the S&P 500 universe
reporting, revenues are down about 10% YoY and the worst is yet to come
because the retailers and homebuilders have yet to report. Even so, on an
apples-to-apples comparison, sales were -16% YoY in 1Q and -14% in 4Q of
last year, so the bulls (who have thus far been correct) would say that this is a
classic ‘green shoot’ second-derivative improvement in the data. The revenue
declines have cut a wide swath, with 9 of the 10 sectors and 3 in 4 companies
posting contractions.

For those believing the recession is over, let’s just say that in the context of an
economy that is not in recession, the odds of seeing a negative quarter for
revenues is 1-in-13. And, just how bad is a -10% quarter for sales revenues?
Well, it would tie the fourth worst performance of the past decade. To put it
into perspective, when the 2001 recession ended, sales were running at -1.0%
YoY — what we have now is worse by a factor of ten. And, when the last bull
market was confirmed in the spring of 2003, sales had already swung well
into positive territory on a YoY basis.

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BIG WEEK AHEAD FOR THE BOND MARKET

The U.S. government is going to flood the market with newly minted Treasuries A flood of newly minted
this week — $200 billion, which will make this the busiest week in 24 years. Treasury securities hits
As of this month, the gross supply of Treasury security issuance has come to the market this week
$1.25 trillion, up from $434 billion last year and $350 billion at this juncture
of 2007. With the yield on the 10-year note still south of 4.0% this attests to
the offset from intense deflationary pressures, though the deteriorating fiscal
performance and outlook has generated a super-steep yield curve and for the
time being established a higher floor for longer-dated yields.

This week, we will see records in the new issuance of 2s, 5s, 7s — a total of
$109 billion, which compares to $104 billion at the June auction and $102bln
in May. See page C1 of the WSJ for more.

UPDATE ON THE EMPLOYMENT SCENE

This got very little play, but the minimum wage was lifted on Friday to $7.25
an hour from $6.55 — a 10.6% increase. That may be great news for the 5
million workers that are affected, but it will likely trigger reduced job creation
too as sectors like restaurants and hotels move to contain their aggregate
labour bill.

We have said before that the unemployment rate is very likely to continue to
rise for the next few years, not just quarters, and that it will take out the
November-December 1982 post-WWII peak of 10.8%.

Why is that?
First, it should be noted that in the last cycle, the recession ended in
November 2001 and yet the unemployment rate did not reach its peak until
June 2003. Considering that the asset deflation and credit collapse this time
around was so acute, why would anyone think that it will take less time to
reach the peak in the current cycle?

Second, this cycle was most unusual in that 9 million full-time jobs were lost
and of these, 3 million were pushed into part-time work. There are now a
record 9 million people working part-time that would rather work full-time,
which is about 5 million above the norm. On top of that, companies cut the
hours worked by a record 2.3% to an all-time low of 33.0 hours this cycle,
which is equivalent to another 3 million jobs being lost. So in sum, we have a
total level of unemployment and underemployment that comes to 8 million
and that is without precedent. So when it comes time to add to labour input
again, what businesses are going to do is to raise the workweek and push the
part-timers back to full-time work before embarking on a hiring spree. In the
meantime, the usual 100,000-150,000 new entrants into the labour force
every month will be looking for work with futility. Keep in mind that when we
are talking about a total pool of existing labour totaling 8 million jobs, that is
equivalent to over five year’s supply during a normal business expansion.

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Third, the hallmark of this recession was the permanent nature of the job
losses that were incurred. Normally, and this includes that period of Ross
Perot’s “sucking sound” of post-NAFTA being siphoned to Mexico, we lose 2
million permanent jobs in a recession. This is classic Schumpeterian ‘creative
destruction’ as the recession expunges the old uncompetitive industries and
paves the way for new more productive sectors — a recession is a painful but
necessary transition to the net cycle as the torch is passed to new
technologies.

But this time around we are really talking about the law of large numbers
because the total increase in the number of people who lost their jobs
permanently exceeded 5 million or twice what is ‘normal’. What happens to
these people remains to be seen but thus far we see nothing in any ‘fiscal
package; except for traditional goodies to induce consumption growth. The
best fiscal policy of all, and the one that is still not being pursued since it
doesn’t offer a ‘quick fix’, is retooling these unemployed individuals, many of
them in their 20s and 30s, and providing them with new skills that will bolster
long-term productivity growth. It is productivity that is the key variable in the
nation’s standard-of-living performance, and yet, this has somehow escaped
the best and brightest economic minds in Washington — at least so far. If we
can manage to improve education, and thereby income-per-capita, then a
whole host of other problems get worked out too — such a affordable health
care (and for a signpost of the problem Obama’s plan is running into within his
own party, see Blue-Dog Democrats Hold Health-Care Overhaul at Bay on the
front page of today’s WSJ (without the blue dogs, there are not enough votes
on the floor to get the Obama health care plan through).

Another way of looking at the situation is that we are going to end up having some
convergence between the popular definition of the unemployment rate and the
more inclusive U6 measure — the former is 9.5% and the latter is 16.5% and this
seven percentage point gap is without precedent. At the peak unemployment rate
of the last cycle in mid-2003, the gap was four percentage points. As the
unutilized labour pool starts to get absorbed again, the U6 is likely to come down
and the U1 likely to go up, and if they converge at a four percentage point gap
again, then look out — we’ll be talking about an unemployment rate well north of
12% before the jobless recovery comes to an end.

NOT GIVING CREDIT, EVEN WHEN IT’S DUE

The front page of today’s WSJ also runs with Loans Shrink as Fear Lingers.
The largest 15 U.S. banks cut their loan book by 2.8% in Q2 — and more than
half of the loan volumes came from mortgage refinancings and credit
renewals among small businesses (to show how broadly based the credit
shrinkage is, 13 of these banks shrank their balance sheet in the second
quarter). New credit creation is practically nonexistent. Capital conservation
remains the order of the day. This is one critical reason why it would likely be
foolhardy to be expecting a normal inventory cycle to come our way merely
because of an arithmetic addition to growth from lower de-stocking in the
current quarter.

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ANOTHER REASON TO BE BULLISH ON EMERGING ASIA

Government efforts are being stepped up to bolster the social safety net and
help bring sky-high savings rates down as the U.S. consumer takes its savings
rate up. This is good news for commodities since there is a much higher
representation of ‘material’ in the emerging market household consumption
basket than is the case for the U.S. household who has become, at the margin,
the buyer of services (recreation, medical, financial). See Asian Nations
Revisit Safety Net in Effort to Bolster Spending on page A2 of the WSJ.

In our view, it is imperative that Asia finds a new source of growth beyond
recurring public sector spending to offset the secular decline in export growth
that will be associated with a retrenchment in demand growth in the
developed world, primarily in the U.S.A. China currently is only the end-buyer
of 22% of the rest of Asia’s exports — it alone is not large enough to provide a
complete offset. It likely pays to have a look at the editorial comment on this
file on page 6 of today’s FT — Too Early to Declare a V-Shaped Recovery.

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Gluskin Sheff at a Glance

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instrument or any derivative related to such securities or instruments (e.g.,
options, futures, warrants, and contracts for differences). This report is not
intended to provide personal investment advice and it does not take into
account the specific investment objectives, financial situation and the
particular needs of any specific person. Investors should seek financial
advice regarding the appropriateness of investing in financial instruments
and implementing investment strategies discussed or recommended in this
report and should understand that statements regarding future prospects
may not be realized. Any decision to purchase or subscribe for securities in
any offering must be based solely on existing public information on such
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issued in connection with such offering, and not on this report.
Securities and other financial instruments discussed in this report, or
recommended by Gluskin Sheff, are not insured by the Federal Deposit
Insurance Corporation and are not deposits or other obligations of any
insured depository institution. Investments in general and, derivatives, in
particular, involve numerous risks, including, among others, market risk,
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or derivative is suitable for all investors. In some cases, securities and
other financial instruments may be difficult to value or sell and reliable
information about the value or risks related to the security or financial
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from such securities and other financial instruments, if any, may fluctuate
and that price or value of such securities and instruments may rise or fall
and, in some cases, investors may lose their entire principal investment.
Past performance is not necessarily a guide to future performance. Levels
and basis for taxation may change.
Foreign currency rates of exchange may adversely affect the value, price or
income of any security or financial instrument mentioned in this report.
Investors in such securities and instruments effectively assume currency
risk.
Materials prepared by Gluskin Sheff research personnel are based on public
information. Facts and views presented in this material have not been
reviewed by, and may not reflect information known to, professionals in
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intended to express any legal conclusion, opinion or advice. Investors
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subject matter of this report. Gluskin Sheff research personnel’s knowledge
of legal proceedings in which any Gluskin Sheff entity and/or its directors,
officers and employees may be plaintiffs, defendants, co-defendants or co-
plaintiffs with or involving companies mentioned in this report is based on
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any such proceedings have not been reviewed by, discussed with, and may
not reflect information known to, professionals in other business areas of
Gluskin Sheff in connection with the legal proceedings or matters relevant
to such proceedings.
Any information relating to the tax status of financial instruments discussed
herein is not intended to provide tax advice or to be used by anyone to
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Sheff and its affiliates) was obtained from various sources and Gluskin
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Content contained on such third-party websites is not part of this report and
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Sheff.
All opinions, projections and estimates constitute the judgment of the
author as of the date of the report and are subject to change without notice.
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