Breakfast With Dave 091709

David A. Rosenberg Chief Economist & Strategist [email protected] + 1 416 681 8919

September 17, 2009 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING Not much to report in terms of data flow. Equities around the planet are bid yet again as Asia reaches fresh 12-month highs. Bonds are flat in the U.S.A. but selling off overseas. The U.S. dollar is weak and that is helping maintain a positive tone to the gold price. Imagine that, bullion is north of $1,000/oz at a time when the U.S. CPI is -1.5% YoY — imagine what gold will do if (when?) that inflation rate turns positive. As we discuss below, the incoming economic data in both the U.S. and Canada have improved and for the most part bettering expectations. The dilemma is that market pricing has moved far beyond the fundamentals. Despite the temptation to jump into a “liquidity-induced” rally, and these rallies can often take you to heights that you can never imagine we would get to, they cannot be sustained without a durable organic economic expansion. The problem is that the global economy in general, and the U.S. economy in particular, is operating on so much medication that it is difficult to conduct an appropriate examination of the patient at the current time. All we know is that the markets seem to have very rapidly now priced in three years worth of recovery. NO MATTER HOW YOU SLICE IT, THE DATA FLOW IS IMPROVING (MODERATELY) There definitely seems to be more momentum being built up in the economy (and the markets) than we had been expecting for the current quarter and it now looks like a fourth quarter relapse in the economy or the markets is a likely scenario. Our long-term views have not changed, but the equity market has moved beyond green shoots and is sinking its teeth into a better-than-expected slate of positive data, including some upward revisions. Of that there is little doubt. Third quarter GDP could easily come in near 3.5% annual rate and while a 4Q slowdown is to be expected, a move to zero or below now does not seem tenable.

IN THIS ISSUE • While you were sleeping: not much to report in terms of economic data flow, but equities around the world are bid • No matter how we slice it, the incoming economic data in Canada and the U.S. have improved … • … but the problem is that market pricing has moved far beyond the fundamentals • U.S. industrial production came in better than expected in August … • U.S. housing data still look soft, despite all the assistance from Uncle Sam • U.S. CPI data for August was superb; core CPI came in a tame 0.1% on the month • Loonie likes the Canadian data • Mr. Market is on steroids

The industrial production data was a case in point. The headline in August came in at +0.8% MoM, as with retail sales, well above expected, and July was revised up, to +1.0% from +0.5%. This is only two months worth of data after a string of declines but the numbers did come in above our expectations, especially in view of the weakness in the August nonfarm payroll report. Productivity must still be booming to garner a 0.8% increase in production (+0.6% in manufacturing) with payrolls down 63k and a stagnant workweek.

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September 17, 2009 – BREAKFAST WITH DAVE

What caught our eye was that unlike July, not all of the growth in production was due to the auto sector, though it posted a 5.5% bounce on top of the 20.1% increase in July. Excluding auto, production rose 0.6% last month (after a 0.3% gain in July) and that sounds very impressive but a whole lot of that came out of a 1.6% surge in food & tobacco output — the sort of increase in this sector that comes around every five years or so. It should be noted that outside of autos and food/tobacco, manufacturing output was up 0.2%. That is an okay number and not necessarily deserving of a huge market rally, but at least modestly positive.

U.S. economic data have been coming in very strong …

Outside of these two sectors, manufacturing activity was mixed to fractionally better. Machinery output was up 0.8% on top of a 0.6% advance in July, which is good news for ‘old economy’ capex. Production of materials rose 0.6% and this was in addition to the 1.3% bounce in July, while mining rose 0.5% on the month attesting to the strength in the resource sector. But there were plenty of industries that did struggle in August. Production in the defense/aerospace industry stagnated; ditto for construction supplies. Tech posted a 0.5% decline in its first setback since May — computer production down 1.2%, semiconductors down 0.6% and telecom equipment was flat. Consumer non-auto durables fell 1%. Industry operating rates remain very low, but are off the bottom — rising from all time lows of 65.1% in manufacturing in June to 66.1% in July to 66.6% in August. The sectors that have seen the greatest improvement have been primary metals, autos, apparel, food/tobacco, chemical manufacturing, and mining.

… But the big question is how this is sustainable with the consumer not joining the party

The big question is how it is that retail sales have been so firm (if you believe the data) with consumer credit contracting at a record rate and the news yesterday that real average weekly earnings fell 0.2%, and this key metric has been flat or down each month this year. HOUSING DATA STILL LOOK SOFT The NAHB index also edged higher but by an uninspiring 1 point to 19 in September. This was widely expected but it does pay to note that this 19 print, in what supposedly is the hottest sector of the economy (housing, with all the assistance from Uncle Sam), is actually still below the worst levels of the past two recessions. One also has to wonder what the implications are of the “sales expectations” sub-index falling to 29 from 30 means (or last week’s 10.3% plunge in mortgage applications for new purchases — down 34% from already depressed year-ago levels) — especially in the context of all the government incursions into the real estate market to prop it up.

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September 17, 2009 – BREAKFAST WITH DAVE

U.S. CPI DATA SUPERB While the bond market sold off yesterday, one has to be encouraged by the CPI data. The core was only +0.1% MoM for the second month in a row (actually, August was +0.07%). Even adjusting for Cash-for-Clunkers, the core would be 0.16%, so still very tame. Many sectors are having trouble seeing much in the way of any pricing power in the retail sector. The YoY headline inflation rate, even with the recent boost from energy prices, is running at -1.5% YoY. And, the core index, which excludes food and energy, is now down to +1.4% and within distance of taking out the 2003 low of 1.1%.

Many sectors are having trouble seeing much in the way of any pricing power

Again, in terms of sectors with any pricing power, it was lean pickings, and those that looked to have any pricing power seem to have been seasonal in nature. • Air fares rose 1.6% in August on top of a 2.1% boost the month before. • Hotels rose 0.5% and, believe it or not, are up in four of the past five months. • Apparel was little changed but that followed two very positive months and

since May prices have strengthened at a 5.0% annual rate. • Movie theatre prices jumped 1.4% and have now risen four months in a row. • Delivery services (Fedex, UPS) jumped 3.3% and this came on the heels of a

0.5% increase the month before. • Hospital services posted a respectable 0.5% gain as well last month.

But there were steep declines in many other areas too: Jewelry, video-audio equipment, home improvement, appliances, furniture, sporting goods, apartment rents, and autos. In other words, wide swaths of the discretionary or cyclical areas of consumer spending continue to lose pricing power. LOONIE LIKES THE CANADIAN DATA The Canadian dollar should really like the headline and details of that manufacturing report that was released yesterday. Not only were July shipments up a resounding 5.5%, but this was on top of a 2.2% runup in June and it transcended the auto sector revival as 15 of 21 industry groups posted gains. Excluding autos, sales were up 2.1% as well. MR. MARKET IS ON STEROIDS Not much more to say. The S&P 500 is now up more than 60% from the lows, which is truly amazing and kudos to those who called it. But the question is whether the fundamentals will ever catch up to this level of valuation — usually after a 60% rally, we are fully entrenched in the next business cycle. Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs (as may as were lost in the entire 2001 recession).

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September 17, 2009 – BREAKFAST WITH DAVE

It is acknowledged by all the pundits that the recession is over, even though we can see that only industrial production and maybe with the help of the government, real sales, but employment and real income are still falling from where we sit. So dating the end of the recession as the NBER did in late 2001 is one thing just because industrial activity troughs, but it took several quarters for income and employment to bottom back then, so we had a listless recovery in 2002 and a stock market that did not really embark on a sustainable rally until mid-2003. A recession coming to an end is one thing, but sustainable market rallies require solid recoveries. The stock market right now believes that we are going to see that V-shaped recovery, but we remain skeptical since post-credit bubble collapses typically see consumer spending, which is over 70% of GDP right now, sputter even as other line items, such as government spending, kick into gear. In any event, it’s not even worthwhile debating the economic outlook at this juncture. It’s about how much good news is already being discounted in the equity market, and believe it or not, there is more good news being priced in today than there was bad news being discounted back at the March lows. This is an overbought and overpriced equity market and we remain of the view that there is too much risk and too much growth being discounted to be a full participant. It is not apparent today, to be sure, but it will be — if not by the fourth quarter, then certainly by the first quarter of next year — that there is not going to be normal recovery following what was an abnormal credit-induced recession. We say that knowing how forgiving Mr. Market is today over any adverse data points, and how giddily it is responding to positive news. We have preferred to express any procyclical views in the fixed-income market where corporate bonds provide better income than a 2% dividend yield, better downside protection if there is a relapse, and a more reasonable assessment of the economic climate that lies ahead.

Will the fundamentals ever catch up with the current levels of valuation in the market?

In our view, this is an overbought and overpriced equity market

Investors who are tempted to jump into equities should acknowledge that what we have on our hands today is not a normal market. By the time the U.S. stock market rallied 60% off the October 2002 lows, we were into July 2005. We were into the third year of the expansion. Go back to the onset of the prior bull market in October 1990 — by the time we were up 60%, it was January 1994! It took almost a year to accomplish this feat coming off the 1982 lows too and back then, we had lower interest rates, lower inflation, lower tax rates, lower regulation and an eight-year uninterrupted economic expansion to sink out teeth into. So we are witnessing something truly without precedent — a 60% surge off a low in six months. This didn’t even happen in the 1930s!

What we have on our hands today is not a normal equity market

The counter-argument, of course, is that the market this time around is coming off massively oversold lows. Not true. The market was far more oversold and the internals were much more compelling at the 1982 and 1990 troughs. The multiples on price-to-earnings and price-to-book, not to mention dividend yields, were much more attractive at the other lows.

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September 17, 2009 – BREAKFAST WITH DAVE

No doubt we had a financial scare at the March trough, but valuation at the time was priced for -2.5% real GDP growth and $50 EPS, which is hardly Armageddon even if a bad outcome. And while it is true that the S&P 500 slid 60% from peakto-trough, we have news for you — so did corporate earnings. In any event, this is the same market that lost its marbles in 2007, hitting fresh all time highs by October of that year with visions of new definitions of global liquidity, and at the time it was pricing in 5.5% real economic growth for the coming year. Instead, we had zero growth on average. Mr. Market is a discounting barometer to be sure, but he is not always right.

Our overall fundamental views and our outlook for 2010 have not changed at all and neither has our investment philosophy

To reiterate, while acknowledging the obvious, which is that there is more momentum in the economy and the markets over the short-term than we had thought would be the case. However, our overall fundamental views and our outlook for 2010 have not changed at all and neither has our investment philosophy. If the S&P 500 was hovering closer to 800 or 850 right now, we could see the case for equities, but the market has simply moved too fast and is way ahead of the fundamentals, even if they do turn positive. Understanding that equities are a long duration asset, we have found over the years that investors have shortened their time horizons, and while it has become fashionable to price the market on an earnings stream three years out, the error term around any profit projection that far out is extremely wide. All we know is that as far as the coming year is concerned there is currently more room for disappointment than there is for upside surprises. There is too much growth priced into the market and equities remain highly risky. Then again, this is a market that is “all in” on the V-shaped recovery view and it will likely take some shockingly weak data points to shake this conviction. By and large, the data are coming in above consensus estimates and there could well be enough of a spillover into 4Q to prevent a complete relapse, thought 2010 remains a wild card. We also cannot underestimate the extent to which the government, having invoked multiple stimulus measures, from becoming even more aggressive. We are hearing rumblings that not only will the $8,000 first-time homebuyer tax credit be extended beyond the November 30 expiry date, but that the cap will be raised significantly. Damn the torpedoes, full steam ahead — there’s a mid-term election to fight in 2010.

We must reiterate that there is too much priced into the market and equities remain highly risky

Sentiment is clearly bullish, which normally would indicate an overbought market, but as we said earlier, these are far from normal markets. According to the latest Investors Intelligence poll, bulls command a 47.8% share of the respondents and bears are at 24.4%. Only 27.8% are in the “correction” camp, which is startling considering (i) how extended this rally is, and (ii) the time of year we are in.

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September 17, 2009 – BREAKFAST WITH DAVE

We noted yesterday that the Nikkei posted six 20%+ rallies since its bubble burst in 1990 and no fewer than four 50%+ rallies. Indeed, you can count 423,000 rally points from all the up-days since the secular bear market began in 1990 and yet the index is down 74% since that time. So actually there is nothing in this flashy move off the lows in the S&P 500 that is inconsistent with a pattern of a bear market rally — this is not the onset of a whole new sustainable bull market, in our view. These are rallies than can only be rented — not owned, and are purely technically-motivated and momentum-driven. They are not premised on improved fundamentals, despite economic data that are skewed to the upside by rampant government intervention. Just remember — nobody ever built more bridges or paved more river beds to skew the economic data than the LDP did in Japan for much of the 1990s.

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September 17, 2009 – BREAKFAST WITH DAVE

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