David A.

Rosenberg September 18, 2009

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHO IS DOING THE BUYING?
IN THIS ISSUE
Is it the private client? Not really — stock funds actually had net outflows of $1.33
billion last week, while bond funds enjoyed an $8.2 billion net inflow. • Who’s doing the buying in
the equity markets?
Is it corporate insiders? Well, heck no — Robert Toll (CEO of Toll Brothers) just
• In our view, there is way
disclosed that he sold a total 1.6 million shares of his company’s stock yesterday. too much risk in the U.S.
equity market
Is it buybacks? Not at all — in fact, S&P 500 companies bought back a mere
• We remain long-term
$24.4 billion on stock repurchases in 2Q, down 72% from a year ago and the
commodity bulls, but the
lowest in recorded history, according to Howard Silverblatt of Standard & Poor’s. near-term outlook is
clouded
So who’s doing the buying? Very likely it is still a combination of program trading,
• The Philly Fed
short coverings and portfolio managers desperately trying to make up for last
manufacturing index now
year’s epic losses. stands at its best level
since June 2007 …
WAY TOO MUCH RISK IN THE EQUITY MARKET
• … But don’t uncork the
Never before has the S&P 500 rallied 60% from a low in such a short time frame champagne just yet, the
as six months. And never before have we seen the S&P 500 rally 60% over an components were mixed
interval in which there were 2.5 million job losses. What is normal is that we see to slightly negative
more than two million jobs being created during a rally as large as this. • U.S. initial jobless claims
decline, but we are not
In fact, what is normal is for the market to rally 20% from the trough to the time out of the woods yet
the recession ends. By the time we are up 60%, the economy is typically well into
• U.S. housing market;
the third year of recovery; we are not usually engaged in a debate as to what carving out a bottom but
month the recession ended. In other words, we are witnessing a market event still quite soft
that is outside the distribution curve.
• Consumers still not out of
the woods
While some pundits will boil it down to abundant liquidity, a term they can seldom
adequately defined. If it’s a case of an endless stream of cheap money, we are • U.S. household net worth
reminded of Japan where rates were microscopic for years and the Nikkei certainly rebounds, but the
deleveraging process still
did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market has a ways to go
that is still more than 70% lower today than it was two decades ago. Liquidity and
technicals can certainly touch off whippy tradable rallies, but they don’t take you
all the way to a sustainable bull market. Only positive economic and balance
sheet fundamentals can do that.

Another way to look at the situation is that when you hear and read about
“liquidity” driving the market, it is usually a catch-all phrase for “we have no
clue” but it sounds good. When we don’t have a reasonable explanation for
what is driving prices our strategy is to watch from the sidelines and express
whatever positive views we have in the credit market and our other income and
hedge fund strategies.

Please see important disclosures at the end of this document.

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
September 18, 2009 – BREAKFAST WITH DAVE

As for valuation, well let’s consider that from our lens, the S&P 500 is now priced In just six months, we have
for $83 in operating EPS (we come to that conclusion by backing out the earnings managed to take the P/E
yield that would match the current inflation-adjusted Baa corporate bond yield). multiple on the S&P 500
That would be nearly double from the most recent four-quarter trend. Not only above the peak of the last
that, but the top-down estimates on operating EPS, for 2009 are $48.00 for 2009; cycle when the economic
$52.60 for 2010; $62.50 for 2011; and $81.00 for 2012. The bottom-up expansion was five years
consensus forecasts only go to 2010 and even for this usually bullish bunch, old, not five weeks old
operating EPS is seen at $73.00 for 2010, which means that $83.00 is likely a
2011 story. Either way, the market is basically discounting an earnings stream
that even the consensus does not see for another two to three years. In other
words, this is more than just a fully priced market at this point.

It is, in fact, deeply overvalued at this juncture. Imagine that six months after the
depressed lows we have a situation where:

• The trailing price-earnings ratio on operating EPS is 26.5x. At the October

2007 highs, it was 18.8x. In addition, when the S&P 500 is trading north of a
26x P/E multiple on trailing operating earnings, history shows that at these
high valuation levels, the market declines in the coming year 60% of the time.
• The trailing price-earnings ratio on reported EPS is 184.2x. At the October
2007 highs, it was 23.4x. In fact, just prior to the October 1987 crash, the
P/E ratio was 20.3x (not intended to scare anyone).
• The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the
market is trading as it if were at a peak for the cycle, not any longer near a
trough. Once again, and we don’t intend to sound alarmist, the price-to-
dividend ratio just prior to the 1987 crash was 12x, and at the time, the S&P
500 was viewed in many circles to be at an extended extreme.

Bullish analysts like to dismiss the actual earnings because they are “depressed”
and include too many writeoffs, which of course will never occur again. Fine, on
one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the
highest it has been in nearly five years. At the peak of the S&P 500 in the last
cycle — October 2007 — the forward P/E was 14.3x, and the highest it ever got in
the last cycle was 15.4x. So hello? In just six short months, we have managed to
take the multiple above the peak of the last cycle when the economic expansion
was five years old, not five weeks old (and we may be a tad charitable on that
assessment). As an aside, the forward multiple on the eve of the 1987 stock
market collapse was 14x and one of the explanations for the steep correction was
that equities were so overvalued and overbought that it was vulnerable to any
shock (in that case, it came out of the U.S. dollar market). It certainly was not the
economy because that sharp 30% slide took place even with an economy that was
humming along at a 4.5% clip.

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September 18, 2009 – BREAKFAST WITH DAVE

In other words, valuation may not be the best timing device, but it still matters.
If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% real We believe that the U.S.
GDP growth, we would certainly be interested in boosting our allocations equity market remains an
towards equities. But at 1,060 and over 4.0% GDP growth effectively being overvalued, overbought
discounted, we will be spectators as opposed to participants, understanding and overextended market
that the key to success is to NOT buy at the peaks. So the strategy is to sit on
the sidelines, be selective in our equity choices, and wait for the correction to
come or for the fundamentals to catch up with this overvalued, overbought,
overextended market. Remember, the reason why the tortoise won the race
was because the hare got tired.

One more thing, when people look back at this period, they are very likely going to
ask themselves why it was that they never paid attention to the volume data,
which, like the bond and money market, never confirmed the veracity of this very
flashy bear market rally. We reiterate, Japan enjoyed four of these 50% power
surges in the context of a market that is still down over 70% from its highs of two
decades ago. So remember, rallies in a bear market are to be rented; never
owned. For those that never took the opportunity to get out at the lows today have
this glorious chance to do so at much better prices, but the question is whether
greed has overtaken their long-term resolve, especially now that Gordon Gekko is
making a return to the big screen.

LONG-TERM COMMODITY BULLS BUT NEAR-TERM OUTLOOK IS CLOUDED

By what? The evil “I”. As in … Inventories.

Copper prices succumbed yesterday to the latest LME stockpile data, which rose
for the fifteenth day in a row, to 324,375 metric tons — the highest since May 26. We are long-term
As for energy, much of the same story — supplies of distillate fuel rose 2.24 million commodity bulls, but the
barrels to 167.8 million, 24% above average and the most since January 1983. near-term outlook is
The commodity complex is down so far today but we remain secular bulls; clouded
however, let’s face it, if China has completed its buying program for the year, then
it would not surprise us if resource prices press the pause button over the near-
term. (Though the long-term constructive view on the resource sector critically
hinges on the outlook for the Asian economies and on this score, the front page
article in today’s NYT was highly encouraging — China’s Economy is Roaring Back.

We are also fans of the Canadian dollar on a trend basis, but again, it overshot
the fundamentals on a near-term basis when it broke above 94 cents level very
recently. We do not like the U.S. dollar at all, but at the same time, from a purely
tactical standpoint, we have to recognize that there are no U.S. dollar bulls out
there right now, the bearish dollar trade is the crowded consensus trade, and
that the greenback is massively oversold. It could snap back near-term — be
aware of that, please.

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September 18, 2009 – BREAKFAST WITH DAVE

Be that as it may, long-term investors should stick with the currency of the
country that is not going to be raising top marginal tax rates, whose We are also fans of the
government is not going to re-regulating or infiltrating wide swaths of its CAD on a trend basis, but
economy and who understands the importance of reducing barriers to has overshot the
international trade. As the Obama administration cow-tows to the unions and fundamentals on a near-
raises tariffs, the Harper government just announced that it is going to term basis when it broke
eliminate all import duties on machinery and equipment. As today’s Globe above 94 cents level very
and Mail aptly put it, the move by the Canadian government is “reinforcing its
recently
commitment to freer trade even as other members of the Group of 20 nations
slip on their pledge to maintain open markets.”

PHILLY CHEESESTEAK
The Philly Fed index was the latest in a string of indicators suggesting that
industrial activity is remaining solid as the third quarter draws to a close. The
diffusion index rose to 14.1 in September from 4.2 in August and now stands at its
best level since June 2007 — six months before the recession started. However,
before anyone uncorks the champagne, it is worth noting that the components
were mixed to slightly negative. So like a Philly Cheesesteak, the first bite was
great, but then the fried onions start to dominate. To wit:

• Prices paid, a measure of input costs, rose to 14.9 in September from 10.0 in
August — the highest in 13 months. At the same time, prices received, which
measures pricing power, tanked in September, to -10.5 from -1.5 (so much for
the reflation/inflation chatter).
• New orders edged down to 3.3 from 4.2 in August.

• Inventories actually swung to -18.1 (worst level since May) from +0.3 in
August.
• Employment declined to -14.3 from -12.9 (though the workweek did improve
to -3.9 from -6.4).
• The six-month outlook index fell to 47.8 from 56.8 and the nearby June high The latest Philly Fed
of 60.1 — now at its lowest level since April. manufacturing survey is
• Pricing intentions rolled back to a three-month low of 9.7 from 13.6 in August. like a Philly Cheesesteak
— the first bite is great,
Based on the research that has come our way, the ISM-adjusted figure actually but then the fried onions
broke a five-month string of gains with a modest drop, to 47.5 in September from start to dominate
48.9 in August. The bottom in ISM led the bottom in equities by three months so
keep an eye on any peaking out.

JOBLESS CLAIMS DECLINE

Initial jobless claims in the U.S. managed to climb over some pretty aggressive
seasonal factors for the week of September 12 — down 12,000 to 545,000. But
the raw non-seasonally adjusted data showed a plunge, from 466,000 to 408,000
— the lowest in a year. The four-week moving average is at 563,000 and frankly,
this is still consistent with a near 200,000 nonfarm payrolls decline.

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September 18, 2009 – BREAKFAST WITH DAVE

Continuing claims rose 129k to 6.23 million so there really is no sign of any new
hirings taking place — consistent with the latest Manpower intentions survey. The Yes, U.S. housing starts
insured unemployment rate edged up to 4.7% from 4.6%, and extended benefits rose 1.5% MoM in August,
rose a further 32k too for the August 29th week. It truly is difficult to say anything but what was key was the
inspiring here about the labour market in the U.S. but then again, who needs to 3.0% decline in single-
hire when Corporate America can shed 63k factory jobs in the same month that it family starts
boosts manufacturing output at a 7.8% annual rate?

While it is now considered to be in very bad taste to say anything negative about
an equity market that is seemingly on a one-way ticket north, by the time the S&P
500 was up 60% in the last cycle, claims had already fallen to 300k. And, in the
cycle prior to that, claims had drifted down to 350k by the time the market had
rallied 60%. The market is so overextended that it is now 20% above its 200-day
moving average, which is a technical condition that has not occurred in 27 years.

HOUSING … CARVING OUT A BOTTOM BUT STILL QUITE SOFT

What was key in the August housing starts data in the U.S. was that single-family
starts were actually down 3.0% to a 479k annual rate, fully offsetting the July gain.
Single-family permits have clearly carved out a bottom but they did pause (-0.2%
MoM) last month as well. Housing completions sank 5.5% and units under
construction fell 2.8% and these will weigh on construction activity over the near-
term in terms of the expenditure data.

Multi-family starts surged 25% to a three-month high of 119k units at an annual

rate. That’s all we need, more “multis” with a nationwide apartment vacancy rate
at a record of 10.6%. For the first time on record, this 30% chunk of the CPI,
otherwise known as residential rents, has dipped now for two months in a row —
and something tells us that more is to come.

CONSUMER STILL NOT OUT OF THE WOODS

If you mine the data, you will see that there was less to the blowout retail sales Yes, U.S. retail sales were
data for August than met the eye. Once the aggressive seasonals are factored, a blowout, but remember
you can actually build the case that there was very little or no growth in the core the new focus on frugality
number. Let’s go to the real world and away from the Commerce Department data by the U.S. consumer will
for a second. Wal-Mart’s CEO said yesterday that “our customers have been under persist for a long time
a real strain” and that the paycheck cycle has “been more exaggerated and
pronounced in recent months.” He added (near and dear to our Ozzie & Harriet
hearts) … “This new focus on frugality, and especially on the deferral of purchases
for things that aren’t needed right now, are the new normal … I don’t believe this
will change as the economy gets better. The deferral of purchases will be with us
for a long, long time.”

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September 18, 2009 – BREAKFAST WITH DAVE

A just-released Bloomberg poll shows that only 8% of households intend to lift

spending; one-third say they intend to spend less. The only way it would seem to The post-bubble
prop up the consumer is by recurring rounds of government stimulus. Indeed, deleveraging continues,
don’t look now but there is a bill in Congress, introduced by Senator Johnny and absent recurring
Isakson from Georgia (a Republican no less!), proposing that the $8,000 first-time bouts of generosity from
homebuyer tax credit (supposed to expire at the end of November) be expanded to Uncle Sam, the U.S.
$15,000 and made available to everyone (besides being limited to “newbies” right consumer will remain in
now, there are income caps at $75k per individual and $150k for couples). Not
the doldrums as far as the
eye can see
only that, but the Obama administration is now engaged in talks with the Treasury
department — the discussions centre around providing aid to jobless homeowners
who are having trouble meeting their mortgage payments (that there is a private
insurance sector that provides this to people who buy a home is somehow
immaterial — the government south of the border is concentrating less on the
taxpayer and more on nurturing a welfare state).

Note as well (you can see this on page C12 of the WSJ — Uncle Sam Bets the
House on Mortgages) how the long arm of the law has been extended to the
residential real estate sector. Fully 85% of new mortgages being issued are
receiving government support in the form of guarantees (the three banks
dominating the market must be making out like bandits)! What is amazing is
that we are really seeing only nascent improvements in housing demand and
mortgage growth. In fact, as a sign of how the government is pushing on a
string, consumer attitudes towards this ball and chain called real estate and the
leverage that goes with it, mortgage applications for new purchases are down
30% from the already deeply depressed levels of a year ago. What’s that saying
again about bringing the mule to water?

U.S. HOUSEHOLD NET WORTH REBOUNDS

The dramatic rally in the equity market (which has effectively taken valuations to
late-cycle, not mid-cycle levels by the way), along with the stability in home
prices (at least for now), helped boost U.S. household net worth by $2 trillion in
the second quarter. But the reality is that this rebound recouped very little of
the $14 trillion that was lost in the prior two years, and still leaves a gaping $12
trillion hole in the household balance sheet. The problem is that with 12 months
of total unsold housing inventory, when the shadow supply from the banking
sector is added in, will limit any potential for further home price gains and in fact
leaves real estate valuation vulnerable to a further downleg, especially at the
high-end market where excess supply is particularly acute. Moreover, valuations
in the equity market are now far less compelling and are likely to cap the stock
market or perhaps even leave the market vulnerable to negative returns in the
coming year, if history is any indication.

What really caught our eye, and one of the principal reasons why net worth
improved, was the huge $48 billion decline in total household debt, bringing the
cumulative runoff from the fourth quarter of 2008 to an unprecedented $200
billion. The post-bubble deleveraging continues, and absent recurring bouts of
generosity from Uncle Sam, the consumer will remain in the doldrums as far as
the eye can see.

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September 18, 2009 – BREAKFAST WITH DAVE

Remember Bob Farrell’s rule number 2: “Excesses in one direction will lead to an
opposite excess in the other direction.” The household sector is in the early stages Remember Farrell’s rule
of unwinding a secular excessive credit cycle that began a quarter-century ago, #2: “Excess in one
which turned parabolic in 2001 with the onset of the Bush ‘ownership society’, direction will lead to an
and all the leverage that came with it from low-doc loans, to no-doc loans, to liar opposite excess in the
loans, to stated-income loans, to piggyback loans, to subprime loans, and finally to other direction.”
option ARMS and “neg-ams”. Dialing back to the “mean” would mean slicing the
household debt ratio by half and this in turn entails $7 trillion of debt repayment.
So, consider the $200 billion of credit reduction to date a very small down-
payment on what promises to be a deleveraging phase that can easily last a
decade. Sushi anyone?

CHART 1: CONSUMER DELEVERAGING HAS A LONG WAY TO GO

United States: Household Credit Market Debt to GDP
(ratio)

1.1

0.9

0.7

0.5

0.3
60 65 70 75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

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September 18, 2009 – BREAKFAST WITH DAVE

Gluskin Sheff at a Glance

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