Breakfast With Dave 092109

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

September 21, 2009 Economic Commentary

5B4B3B2B1B0BMARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING Some profit-taking seems to be taking center stage with global equities losing ground today, bonds modestly bid and the U.S. dollar rebounding from the abyss (have a look at European Commercial Property Owners Face Debt Time-Bomb on page 17 of today’s FT and you start wondering whether the Eurozone is in even worse financial shape than the U.S.A.). This is actually the second day that the world MSCI index has slipped after a very flashy six-month rally that has taken equity values into overvalued terrain — and in the case of the U.S.A., into a zone that is generally reserved for the third year of economic expansion as opposed to the current government-induced tentative move out of recession. The commodity complex is losing ground today and gold has retreated back below the $1,000/oz threshold (the IMF’s executive board just approved a sale of 403.3 metric tons at a value of about $13bln; and gold consumption in India has plunged 38% YoY — see Gold ETFs Push Bars, Coins Aside on page C2 of the WSJ). Copper is responding to news that LME stockpiles have risen to fourmonth highs — a respite is in order after prices doubled this year. Note that the Baltic Dry Index sank 4.5% last week (and off 45% from the early-June highs) and as such may be signaling more near-term price declines in the commodity space. So, in our view, a healthy correction would be a welcome development. Oil is riding a three-day decline and seems stuck in a $69-72/bbl range. It’s quite the active week ahead. We have the G20 meeting on September 2425 in Pittsburgh where investors will be watching for any clues over how global bank regulation in the future is going to look (executive pay curbs, de-linking commercial and investment banking, more stringent capital adequacy rules, lower acceptable leverage ratios). We also have the FOMC meeting on September 22-23 and the question is the extent to which the Fed sounds an optimistic chord in the press statement and whether there will be a reference to more mortgage purchases or whether the emphasis will be on exit strategies from the unprecedented credit easing moves that have taken place.

IN THIS ISSUE • While you were sleeping — some profit-taking overnight with global equity markets and commodities losing ground • It’s quite an active week ahead — FOMC confab and the G20 meeting, U.S. treasury auction and U.S. housing data released • The new frugality is a secular theme — consumers are cutting back and scaling down • Equity market est tres expensif — the S&P 500 is trading north of a 26x P/E multiple • What the macro landscape looks like when the markets rally 60% from the low • Is Jim Grant the latest to be drinking the Kool-Aid?

Data-wise, it is a very light week but what’s coming out has the “housing label” all over it: July FHFA home prices on Tuesday; August existing home sales on Thursday; and new home sales on Friday (along with the final University of Michigan sentiment data for September and August durable goods orders). That Lennar stated that its 3Q loss doubled on sustained revenue losses (-42% YoY) is one sign, at least, that not every slice of the real estate sector is performing as well as everyone seems to think — only the low-end, really, which is on life-support from the slate of government assistance programs.

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 21, 2009 – BREAKFAST WITH DAVE

On deck for the week ahead is a very active Treasury issuance calendar too — the U.S. Treasury will auction off $112 billion of 2, 5 and 7-year notes (a record for the combination of these maturities), breaking the record of $109bln in late August (Bloomberg News runs with a nifty article on this today). For all the talk of a buyers’ strike, what we saw this year was elucidating. In the face of a 15% decline in the trade-weighed dollar, international investors actually stepped-up their buying of Treasury securities mopping up an estimated 43% of the gross new issues at auction time (compared with a 27% share this time last year). China added $24 billion to its U.S. bond holdings in July — its holdings now stand at over $800bln and buying activity is up 10% from a year ago.

Foreign investors continue to buy U.S. treasuries — international investors mopped up around 43% of the gross new issues at auction time

For added reasons as to why bond yields have been so well behaved despite the impressive rally in risk assets in the past six months, see Eager Fed Helps Keep Treasury Rally Alive on page C1 of today’s WSJ, and the article on what households are doing to their portfolio mix on C8 (As Confidence Rises, So Do Inflows: Investors Remain Wary as Bond Mutual Funds Grab Lion’s Share of Money). In the meantime, the IPO market is on fire — another sign that perhaps the rally in equities may be a tad out of hand — five new issues are lined up for the coming week (see article on page C2 of the WSJ). THE NEW FRUGALITY IS A SECULAR THEME U.S. consumers are cutting back, and where they are not cutting back, they are scaling down. This new cycle is all about “getting small” and it is deflationary. For yet another in the litany of signs pointing in the direction of social change towards thrift, have a look at what is transpiring at the upper echelons of the income strata — Now Even Millionaires See the Benefits of Budgeting on page B5 of the Saturday NYT is a must read.

This new frugality theme is all about “getting small” and it is deflationary, in our view

Not only are the rich trading down, but the article quotes a high net worth financial advisor who said “many of our clients are very happy to be sitting on bond portfolios and cash reserves.” And see the article on page 2 of the Sunday NYT — Beauty Products Lose Some Appeal During Recession. According to the NPD Research Group, total sales of department store beauty products are down 7% from year-ago levels. Women are apparently opting for the “natural look” — “some people are selectively replacing higher-priced items with cheaper products from drug stores and discount stores.” Speaking of women, they are coming back into the labour force in droves so as to help underpin sagging family incomes — and this new demographic trend is going to likely be a factor taking the unemployment rate to new highs. See Back to the Grind: Recession Drives Women Who Left the Work Force to Return on page B1 of the Saturday NYT.

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September 21, 2009 – BREAKFAST WITH DAVE

INCOMES UNDER PRESSURE A just-released Bloomberg poll showed that only 8% of U.S. households intend to raise their spending in the coming six months while over 30% intend to cut back. The reason is obvious — incomes are under strain in what is the most underemployed labour market in 70 years. Household income for those in the peak earning years of 45 to 54 years of age plunged $7,700 from 2000 to 2008 to stand at $64,349 (based on the new Census data). Only those 54 and older have seen their incomes rise over the past four years as the aging but not yet aged baby boomers re-enter the labour market in droves to garner the income so as to recoup their lost net worth and allow them to at least maintain some semblance of a comfortable retirement lifestyle.

Household income is under pressure in what is the most underemployed labour market in 70 years

When we say the most underemployed labour market since the 30s, we aren’t mincing words. The unemployment rate hit 10% in 14 states and in D.C. in August, and in California, it actually did reach a 70-year high of 12.2%. EQUITY MARKET EST TRES EXPENSIF The S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings and history shows that at these high valuation levels, the market declines in the coming year 60% of the time. All we know is that we have a trailing P/E multiple (operating earnings) on the S&P 500 of 26.5x — a record eight multiple point expansion from the low over a six-month span. Take note that this is the highest P/E multiple since March 2002, which is right around the time that the bear market rally at that time (also premised on post-crisis V-shaped recovery hopes) began to roll over. It took a good year for the fundamental bottom in the market to be put in, and that was heresy back then too. The P/E multiple on non-scrubbed reported earnings has soared 60 points since March to 184x — not only a record but five times more expensive than what we saw during the peak of the dotcom bubble a decade ago (oh, but we forgot — write-downs don’t matter).

Going back six decades, history shows us that the market typically faces serious valuation constraints once it breaks above the 25x P/E multiple threshold

Going back over the last six decades, we know that the market typically faces serious valuation constraints once it breaches the 25x P/E multiple threshold. The average total return a year out for the S&P 500 is -0.3% and the median is -6.2%. The total return is negative a year later 60% of the time, so when we say that there is too much growth and too much risk embedded in the equity market right now, we like to think that we have history on our side. As for valuation, well let’s consider that from our lens, the S&P 500 is now priced for $83 in operating EPS (we come to that conclusion by backing out the earnings yield that would match the current inflation-adjusted Baa corporate bond yield). That is nearly double from the most recent four-quarter trend. Not only that, but the top-down estimates on operating EPS, for 2009 are $48.00 for 2009; $52.60 for 2010; $62.50 for 2011; and $81.00 for 2012.

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September 21, 2009 – BREAKFAST WITH DAVE

The bottom-up consensus forecasts only go to 2010 and even for this usually bullish bunch operating EPS is seen at $73 for 2010, which means that $83 is likely a 2012 story according to them. 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. The S&P 500 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

How does the U.S. macro landscape look like when the markets rally 60% from the low? Real GDP has expanded by 5.3%, on average Profits are growing at 34%

• The trailing price-earnings ratio on reported EPS is 184.2x • The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the

market is trading as if it were at a peak for the cycle, not any longer near a trough. • The price-to-book ratio is 2.3x. If you want undervalued, try August 1982 —

the onset of an 18-year secular bull market — when the S&P 500 bottomed after trading at a discount to book value.

Employment has rebounded by 2.1mln Bank lending, on average, is growing at a 16.5% pace

If you go to page 14 of the weekend FT, you will see a reference to some Street research assessing market valuation using the Tobin Q — based on this yardstick, equities are currently overvalued by 40%.

ISM is usually at 58.9

WHAT THE MACRO LANDSCAPE LOOKS LIKE WHEN THE MARKETS RALLY 60% FROM THE LOW

And, on average, consumer confidence is at 91.8

• GDP has expanded by 5.3%, on average (now just bottoming out) • Corporate profits are growing at 34%, on average (ditto) • Employment has rebounded by 2.1 mln (still declining) • Bank lending rose an average of 16.5% (ditto) • ISM is at 58.9, on average (now 52.9) • Consumer Confidence (Conference Board) is at 91.8, on average (now 54.1)

IS JIM GRANT THE LATEST TO BE DRINKING THE KOOL-AID? The Weekend Journal ran with an article by James Grant, which admittedly took us by surprise (he is a true giant in the industry, as an aside) — From Bear to Bull and in the article, he relies mostly on the thought process from two economic think-tanks — Michael Darda from MKM Partners and the folks over at the Economic Cycle Research Institute.

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September 21, 2009 – BREAKFAST WITH DAVE

We highly recommend this article for everyone to read to understand the other side of the debate. But we have some major problems with the points being made. 1.

Mr. Grant starts off by saying that “as if they really knew, leading economists predict that recovery from our Great Recession will be plodding, gray and jobless.” Well, frankly, it doesn’t really matter what “leading economists” are saying because Mr. Market has already moved to the bullish side of the debate having expanded valuation metrics to a point that is consistent with 4% real GDP growth and a doubling in earnings, to $83 EPS, which even the consensus does not expect to see until we are into 2012. We are more than fully priced as it is for mid-cycle earnings.

2.

Nowhere in Mr. Grant’s synopsis do the words “deleveraging” or “credit contraction” show up. Yet, this is the cornerstone of the bearish viewpoint. Attitudes towards homeownership, discretionary spending and credit have changed, and the change is secular, not merely cyclical. After all, didn’t consumers just see a record $20 billion of outstanding credit evaporate in August?

3.

Mr. Grant emphasizes (the Darda argument) how we had a huge bounce in the economy after the worst point of the Great Depression (in fact, the subtitle of the article contains: “The deeper the slump, the zippier the recovery”). Well, we didn’t have the Great Depression this time around — real GDP did not contract 25% but rather by 3.7%. We probably have to go now and redefine what a massive slump is. But all we had in the mid-part of the 1930s — between the worst point in 1932 to the 1937-38 relapse — was a statistical recovery, and nothing more than that. Nobody from that era will recall that any year was particularly good — each one was just different shades of pain and sacrifice. By the end of the decade, the unemployment rate was still 15%, the CPI was deflating at a 2% annual rate and the level of nominal GDP, as well as industrial production, still had yet to re-attain its 1929 peak. The equity market in 1941 was no higher than it was in 1933 (and long bond yields were heading below 2%) and even a child knows that it was WWII that brought the economy out of its malaise, not the seven years of New Deal stimulus.

Frankly, it doesn’t really matter what “leading economists” are saying because Mr. Market has already moved to the bullish side of the debate

To concentrate on the wiggles in the U.S. GDP data in the 1930s, no matter how large, totally misses the point about what the decade was really about

So, to concentrate on the wiggles in the GDP data in the 1930s, no matter how large, totally misses the point about what the decade was really about, which was social change, a focus on family, less discretionary spending, and a trend towards frugality that few market pundits seem to comprehend. But the 1930s were the antithesis of the 1920s — not unlike what we are witnessing today. To concentrate on a bungee jump that wasn’t even sustained is akin to focusing on the noise around the trend-line as opposed to the trend-line itself.

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September 21, 2009 – BREAKFAST WITH DAVE

4.

The very sexy argument about how all the government stimulus is going to give the economy a really big lift — combined monetary and fiscal measures are worth 19.5% of GDP. This is viewed as a good thing, of course, but nowhere in the analysis is there a comment about how this “stimulus” is just there to cushion the blow and smooth the transition as wide swaths of private sector credit vanish. We are at the point where 85% of housing activity is still being supported by government interventions. Is this really desirable? According to BusinessWeek, it’s not just the FHA financing 40% of new mortgage originations but the USDA is also allowing builders and lenders to take advantage of rural mortgages that require no-money down and with 100% financing through “a little-known loan program”.

Yes, the massive government stimulus is there to act as a cushion, but what it symbolizes is an economy that is weak and a precarious financial sector

Well, as with most bulls, this new era of state capitalism is a reason to rejoice. But from our lens, what would be more noteworthy would be an article explaining that the massive government incursion with all this “stimulus” is actually more a reason to be concerned than be jubilant — what it really symbolizes is an economy that is so sick that it continues to require massive doses of medication. It’s not what all the stimulus does that matters — of course, it is there to act as a cushion — but it is what all the stimulus has come to symbolize. A fundamentally weak economic backdrop and a precarious banking system that has government guarantees to thank for its survival. We noted last week 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. 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 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 Liberal Democratic Party (LDP) did in Japan for much of the 1990s.

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September 21, 2009 – BREAKFAST WITH DAVE

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