Breakfast With Dave 101309

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

October 13, 2009 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave BREAKING ABOVE 1071.66 1071.66, that was the closing low on the S&P 500 on September 22 — and the S&P managed to set a new post March 9 high of 1076.19 in yesterday’s session. Again, it remains to be seen whether this turns into a key technical development since the Nasdaq, the Dow Transports and the Russell 2000 have not made new highs, so we have some critical non-confirmations here. Be that as it may, this is the sixth time since the March 9 trough that the S&P 500 backed off from an interim high, corrected for a brief time, and then retested and broke that high, to only then make a new interim high. This is exactly what happened yesterday as we Canadians were gobbling their turkeys. Not only that, but after a 21-month stretch of negative YoY returns, the longest since the 1930s, they have just turned positive for the first time since January 2008.

IN THIS ISSUE • Our major strategy remains one of steadfastly focusing on risk-adjusted returns, respecting capital preservation and the need for income in the portfolio • The stock market is divorced from economic reality • Oh Canada! According to Moody’s, Canadian banks are the very best in the world

Beside that, there was another good omen for the bulls. The Dow made it to a new interim high, with the 4% gain last week (best since July 24) taking the basket of 30 stocks to 9865.80. But if there were some bad omens, or certainly what can be classified as cautionary signposts, they were …

• Stronger Canadian dollar eroding the trade backdrop

(i) Volume fell sharply to close out the week. In fact, three of last week’s five upsessions were on lower volume which calls for caution.

• Nice improvement in the U.S. trade deficit … exports have become a bright spot

(ii) Leading stocks are not breaking out, according to the Investor’s Business Daily (IBD) list.

• U.S. chain-store sales beat estimates… but keep in mind that this does not reflect the state of the U.S. consumer

(iii) The only buying seems to be short covering (in the last two weeks of September, short interest on the NYSE plunged 3.4%). (iv) While Q3 S&P 500 operating EPS is seen improving to -23.8% YoY from 31.0% in Q2, the IBD runs with a story showing that outside of financials (where the new accounting rules allow them to hide losses), the YoY trend is actually little improved at -29.0%. Outside of financials, only consumer discretionary EPS is destined to show an increase (of 23.0%) but that had to do with Ford’s massive loss. Basically, the current YoY earnings season is telling you more about Q3 of last year then anything else.

• Very strong Canadian employment data … bullish for the CAD

• U.S. jobs market even worse than we thought

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

October 13, 2009 – BREAKFAST WITH DAVE

(v) The hurdle bar to beat expectations has been raised now that analysts have raised their estimates for 641 companies in recent weeks and lowering just 383 (largest differential in favour of the positives in two years – see Kopin Tan’s ‘The Trader’ column on page M2 of Barron’s).

We still don’t see market fundamentals or valuation as compellingly bullish …

(vi) CEOs are not as pessimistic as they were earlier in the year, but they certainly do not see the V-shaped economic recovery now apparent in equity market valuation. According to a Duke University/CFO Magazine poll conducted in September, more than half of businesses say they will not return to prerecession staffing levels until 2012; fully 43% still plan to cut payrolls in the next 12 months. I still don’t see the fundamentals or valuation as compelling bullish factors and the market looks oversold, based on the 20% gap between today’s price and the 200day moving average; however, there does seem to be an array of other technical indicators (the 52 week new high/new low list) that are supportive over the nearterm. I would have to say that until we manage to see this series of interim highs manage to fail, the technicals can still manage to take the market higher. So keep an eye on whether we break the September 22 high. If we do, then everyone will be talking about a 50% retracement possibility, which then sets the S&P 500 up for a test of 1,120. We should also mention that we were ending off last week with a massive 734 stocks hitting new 52-week highs and 32 hitting new lows. Three sectors, according to the IBD, are very prominent in this 52-week high group, which include golds, retailers and oil & gas equipment. And, while it may be early days, we are seeing some tentative signs of improved revenue results — of the 19 large-caps that have reported thus far, nine beat top-line estimates, nine missed and one met (and 16 of the 19 beat their profit estimates — surprise, surprise). As Kopin Tan reports, of the total universe of stocks, 168 have reported thus far and 71% have beaten estimates — and those that beat saw their stock prices rise an average of 2.4% the following session; those that missed views posted a following-day drop of 4.5%. Those only meeting their targets lost 3.6% so the market is becoming more discriminating, at the margin. Our major strategy remains one of steadfastly focusing on risk-adjusted returns, respecting capital preservation and the need for income in the portfolio, especially for our more mature clients. Great article on the need for a demographic overlay in any strategy on page A9 of the IBD and the sophisticated private investor realizes this — see Baby Boomers Eye Retirement Income on page A9. And portfolios have to be protected against the prospect of a much more pronounced depreciation of the U.S. dollar (and correspondingly, a stronger Canadian dollar) — see the editorial on page 6 of the weekend FT (A Strong U.S. Needs a Weakened Dollar). Also see the commentary on page 9 of Monday’s FT (The Case for a Weaker Dollar).

… but there does seem to be an array of other technical indicators that are supportive over the near term

Our major strategy remains one of steadfastly focusing on risk-adjusted returns, respecting capital preservation and the need for income in the portfolio

Buy gold.

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THE STOCK MARKET IS DIVORCED FROM ECONOMIC REALITY There are some very serious headwinds facing the U.S. economy, and one of them is access to credit for people who are at the lower end of the income spectrum (and who also represent the greatest default risk). A great article on this can be found on the front page of the weekend WSJ (The ‘Democratization of Credit’ Is Over – Now It’s Payback Time). Families at the lower end of the income spectrum spend nearly all of their income, so this is a vital part of the economy and it is going to be very difficult for lower-income families to secure credit going forward. The ratio of credit card debt outstanding to income is 50% higher for the bottom 40% of the income strata than is the case for the upper 40%. The highest default rates are the folks at the bottom of the pay scale. In 2007, fully 35% of poor families had a balance owing on their credit card compared with 21% in 1989. This is the byproduct of government policy inducing lenders to make credit cards available to high-risk, low-income individuals — a reckless policy drive that started in the late 1970s (the policy did help drive homeownership rates up and crime rates down).

There are some very serious headwinds facing the U.S. economy, and one of them is access to credit for people who are at the lower end of the income spectrum

Now that lenders have started to respond to their record-high delinquency rates by rationing credit, a mad scramble for cash is occurring to replace the loans — food stamp usage is up 22% year-over-year, pawn shop business is up nearly 40%, and there is a tidal wave of applications for Social Security disability benefits that are not explained alone by workplace mishaps. In any event, so much effort is being expended by the government to keep the credit cycle going that it isn’t even funny, nor is it useful, anymore. Allowing households to still finance almost 100% of a new house purchase has meant that the FHA default rate for loans made in the last year has surged to 20%; and to 24% for loans made since 2007. Private lenders are now requiring a 20% downpayment, and the credit officers at the FHA only need a 3.5% downpayment. The U.S. taxpayer could be facing up to another $50 billion bailout here. Moreover, the White House plans to induce the banks to modify enough loans to keep 2 million delinquent mortgage borrowers in their homes is proving to be a total flop (see Panel Says Obama Plan Won’t Slow Foreclosures on page B1 of the Saturday NYT) — to the point where Congress is now starting to push the ‘mortgage cramdown’ legislation through — torts, contracts, property rights, we hardly knew ya. Have a look at the article on page 38 of the of the Economist (A New Culture War is Brewing Over Capitalism). Also have a look at Return of the Mortgage Cramdown on page 52 of BusinessWeek. While the subprime market, first-time home buyers and low-income earners have been and will likely remain the primary targets of government relief efforts, the strains in the housing arena are now most intense at the higher end. According to Zillow, 30% of foreclosures are now concentrated in the top one-third of U.S. home values, nearly double the 16% share when the problems in residential real estate were first coming to the fore three years ago. Prime loans now represent 58% of foreclosure starts, up from 44% a year ago.

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October 13, 2009 – BREAKFAST WITH DAVE

Meanwhile, the wave of failed banks continues unabated – we are now up to 98 banks that have failed so far this year. The Sunday NYT ran with an article that half of the $1.8 billion in outstanding commercial real estate loans are sitting on the balance sheets of the small and mid-sized banks. The article cited research by Foresight Analytics who concluded that 581 banks are likely to fail by 2011. As the chart below illustrates, large chunks of the credit market are vanishing. Last week, outstanding bank lending contracted $33 billion, which brings the total decline to nearly $400 billion since the end of May (a 17% plunge at an annual rate). It’s hard to imagine that the economy can gain much traction without recurring government support with the banks calling in their loans at this unprecedented rate. The banks continue to deploy their cash assets into Treasuries/Agencies, having been a net buyer of $30 billion last week and over $50 billion for September as a whole.

98 U.S. banks have failed so far this year and commercial banks continue to call in their loans at an unprecedented rate

CHART 1: BANK LENDING DOWN $400 BILLION SINCE THE END OF MAY United States: All Commercial Banks: Loans & Leases in Bank Credit (16-week change, US$ blns) 400

200

0

-200

-400 75

80

85

90

95

00

05

Source: Haver Analytics, Gluskin Sheff

OH, CANADA! The TSX may not be the diversified market that is characterized by the S&P 500, but the two sectors it is concentrated in has made all the difference in terms of the sustained outperformance — 45% in resources (versus 15% in the U.S.A.), and 32% in financials (versus 15% in the U.S.A.). And for the second year in a row, Moody’s ranked Canadian banks as the very best in the world (U.S. banks ranked 24th in 2009). STRONGER CANADIAN DOLLAR ERODING THE TRADE BACKDROP The Canadian trade balance went in the opposite direction as the U.S.A. — the deficit worsened to $1.985 billion in August from $1.316 billion in July. This was a record deficit and a far cry from the good old days for domestic exporters when the Canadian dollar was flirting near 60 cents a decade ago and Canada was racking up record surpluses at the time of between $6 and $7 billion per month.

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Exports sank 5% and the decline was broad based — machinery producers were particularly hard hit with a 10.4% plunge and down in five of the past six months. The main beneficiaries of the strong CAD are the sectors with high import orientations and that would include the retail/wholesale space. Capital goods producers/tourism the big losers.

The Canadian trade deficit worsened in August, to nearly $2.0bln versus $1.3bln in July

No doubt the Bank of Canada has not been happy with the CAD’s rapid ascent but there isn’t really much it can do outside of jawboning. Senior Deputy Governor Jenkins spoke last Thursday afternoon in Vancouver and again reiterated the line that the strong CAD represents a headwind and though he did hint that the Bank has considerable flexibility in monetary policy, if that was a veiled threat of intervention, it rarely works for more than a couple of days. The bottom line is: (i) The U.S. government wants a weak U.S. dollar policy, rest assured it is going to get one; (ii) So long as the Canadian economic data continues to outperform the U.S., then interest rate differentials will keep the CAD bull market intact, and; (iii) If Asia in general and China in particular don’t relapse like they did from September to March, then any setback in the CAD or any other commodity currency is likely going to be temporary. VERY STRONG CANADIAN EMPLOYMENT DATA … BULLISH FOR CAD Canadian employment surprised to the upside for the second month in a row in September — adding 30,600 jobs in September (versus consensus expectations of 5,000). This follows the +27,100 print in August. This report was even stronger than what we saw in August because …

There is much more labour market slack in the U.S. than there is in Canada

(i) Manufacturing added 26,100 (versus -17,300 in August) — best tally since May 2008. This is very bullish for the CAD. (ii) Full-time jobs surged 91,600 (versus -3,500 in August). (iii) The unemployment rate dropped to 8.4% from 8.7% (it rose from 8.6% in Aug) — though part of this was due to a drop in the participation rate to 67.1% from 67.3%. (iv) The ranks of the unemployed sank 55,200 (versus a rise of 21,900 in August). (v) Hours worked soared 1.6% (after declining 0.7% in August).

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Looking at the headline and all the internals, this was the best Canadian employment report in over four years. It follows in the footsteps of the solid Australian jobs report, and interestingly, the soft U.S. data. So what the means is that the currencies of the countries with a high commodity torque are likely to retain their “premium” over countries like the U.S. with low resource exposure. The fact that the manufacturing sector in Canada could add 26,100 jobs at a time when the U.S.A. posted a 51,000 decline is going to be treated as a sign that Canada may in fact still be competitive with a 90 cent+ currency.

The Canadian employment report for September surprised to the upside … bullish for the CAD

Market chatter of the BoC following the Reserve Bank of Australia in an earlier than planned rate hike is also going to take hold now (Australia also printed a solid September job increase -- +40,600 versus expectations of 10,000). I don’t necessarily believe it, but the prospect of wider Canada-U.S. yield differentials, which will happen even if the BoC drags its heels because the market may start to price in an early tightening, will add to the Canadian dollar’s allure. And, the employment news is great news for PM Harper … maybe he should be the one to call an election. This is all bullish for the Canadian dollar, which has firmed to 97.0 cents (1.0309). Make no mistake, the U.S. government is more than willing to tolerate a soft greenback — see the front page of today’s WSJ, U.S. Stands By As Dollar Falls. Only risk for CAD is if we were to get a seize-up in the markets that would induce a flight-to-liquidity bid again. Not sure how to handicap that, but clearly the fundamentals are with the CAD over the USD. The CAD may still be “overvalued” on a terms of trade basis, but in the FX market, that condition can persist for years. Remember, this is but one data point, and could well say more about Canada’s lagging productivity growth if we don’t see a commensurate improvement in production and manufacturing shipments. We won’t get those data points for last month until we are well into November. Then again, the data suggest that the Canadian consumer is heading into the fall with some decent buying power because the weekly income proxy from the employment report showed a decent 0.7% gain — the fourth increase in as many months. What also caught my eye was the unemployment rate data. The definition of the U.S. labour force is different than it is in Canada, but StatsCan produces a jobless rate that is consistent with the U.S.A. — and the Canadian unemployment rate was 7.6% (non-seasonally adjusted because that is how it reported) versus 9.5% stateside (again, NSA). The all-inclusive jobless rate in Canada (the U6 equivalent) is also much lower here at 10.4% (again, NSAS) compared with 16.1% in the USA.

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There is much more labour market slack in the U.S. than there is in Canada. This may help explain why it is that average weekly earnings in the Canadian household sector rose 0.7% MoM and has gained ground in each of the past four months. By way of comparison, average weekly income in the U.S. fell 0.5% in September and has dropped now in three of the past four months. Regionally, employment improved for all the provinces but what is key for Mr. Harper is Ontario, and specifically the Liberal stranglehold in the Toronto area. Ontario’s unemployment rate declined to 9.2% in September from 9.4% in August and the 9.6% peak in June. Ontario posted a 12,600 net job gain last month and 38,500 in the past three months. Quebec is another wild card given the recent Liberal problems there and Harper can also point to the fact that the unemployment rate in La Belle Province tumbled to 8.8% last month from 9.1% in August.

While net exports may be helping out the U.S. economy, the reality is that the size of the global trade market, like the size of the private sector credits, has shrunk meaningfully in the past year

NICE IMPROVEMENT IN U.S. TRADE DEFICIT — TELECOM EQUIPMENT, SEMICONDUCTORS AND FOOD/BEVERAGES LED THE EXPORT GAIN The U.S. trade deficit came down to $30.71 billion in August from $32.85 billion in July. In real or inflation-adjusted terms, the deficit narrowed by over $1 billion to $37.7 billion and should help add some upside to Q3 real GDP growth estimates, which are currently clustered in a 2.5-3.0% range. What stood out, in terms of solid growth performers, were exports. Exports have become a bright spot having risen 0.2% MoM in August and up now for four months in a row — were semiconductors (+0.7% — also up four months running); telecom equipment (+1.7%) and food/beverage (up 1.2% and this sector has turned in some very nice export gains in four of the past five months). While net exports may be helping out the U.S. economy, the reality is that the size of the global trade market, like the size of the private sector credits, has shrunk meaningfully in the past year. Recurring bouts of trade protectionism and frictions may well exacerbate this trend, but the reality is that the value of global trade flows dropped from $3.85 trillion in 2008 Q2 to $2.58 trillion in 2009 Q2. It was expanding global trade and the breakdown of global barriers that was at least partly responsible from the P/E multiple expansion of the 1982-2000 secular bull market; we are now encountering a reversal of that process. CHAIN STORE SALES BEAT ESTIMATES Depending on what survey is used, sales were fractionally positive YoY compared to expectations of a slight decline (first increase since August 2008). The reasons: • Aggressive discounting pulled in volumes • Late Labour Day took back-to-school sales out August into September • Weather was highly cooperative, especially for apparel • Weak comps from a year ago make current data look flattering • Some possible early signs of pent-up demand, though one wonders then why

auto sales took such a big hit (-35% MoM)

• Value-oriented (discount) and the top teen chains outperformed again and in

the retail arena, this is the segment to focus on

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Remember — THESE ARE SAME STORE SALES AND RETAILERS HAVE CLOSED THEIR WORST PERFORMING STORES. SO THIS IS NOT — REPEAT NOT — A COMMENT ON HOW GOOD THE U.S. CONSUMER HAS BECOME. According to the Fed, nearly 8,300 U.S. stores have been shuttered this year? We are not even much into the fourth quarter and already this far exceeds the 6,900 tally all of last year. The real picture of the U.S. retail sector is highlighted in the retail real estate space, where the nationwide vacancy rate just hit a new 17-year high of 10.3% compared with 8.4% a year ago. Average retail lease rates are now down 3.7% YoY. Moreover, while seasonal merchandise did reportedly sell well in September, the big risk heading into the holiday season is the luxury goods sector. American Express just completed a survey showing that individuals who earn more than $90,000 plan to spend 21% less this year, on average, compared to last year. Another survey by BIGresearch shows that, in total, 3.8% of all households intend to spend the same, 27.3% in the ‘don’t know and don’t celebrate’ category; 29.1% the same; and 39.9% less. U.S. JOBS MARKET EVEN WORSE THAN WE THOUGHT The JOLTS (Job Opening Labor Turnover Survey) survey was just released for August and here is what it showed: • Job openings fell 21,000 to their lowest level in at least nine years • The number of new hires tumbled 199,000 in the worst showing since the

depths of despair last March

• Layoffs and discharges also dropped 108,000 but this was overwhelmed by

the drop in new hirings

• In a sign that workers are losing confidence, the number that quit their current

job fell 39,000 in August

While the continued soft job market is keeping consumer confidence under wraps, the implications of a gutted labour market for profit margins has CEOs perfectly giddy. We say this because the Conference Board’s business confidence index soared from 55 in Q2 to 63 in Q3, the highest since 2004 Q3 and 10 points better than the latest readings on the household front.

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Gluskin Sheff at a Glance 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 the prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted investment returns together with the highest level of personalized client service. OVERVIEW

INVESTMENT STRATEGY & TEAM

As of June 30, 2009, the Firm managed assets of $4.5 billion.

We have strong and stable portfolio management, research and client service teams. Aside from recent additions, our Gluskin Sheff became a publicly traded Portfolio Managers have been with the corporation on the Toronto Stock Firm for a minimum of ten years and we Exchange (symbol: GS) in May 2006 and have attracted “best in class” talent at all remains 65% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and We have a strong history of insightful governance with a private company bottom-up security selection based on commitment to innovation and service. fundamental analysis. For long equities, we Our investment interests are directly look for companies with a history of longaligned with those of our clients, as term growth and stability, a proven track Gluskin Sheff’s management and record, shareholder-minded management employees are collectively the largest and a share price below our estimate of client of the Firm’s investment portfolios. intrinsic value. We look for the opposite in We offer a diverse platform of investment equities that we sell short. For corporate strategies (Canadian and U.S. equities, bonds, we look for issuers with a margin of Alternative and Fixed Income) and safety for the payment of interest and investment styles (Value, Growth and principal, and yields which are attractive 1 Income). relative to the assessed credit risks involved. The minimum investment required to establish a client relationship with the Firm is $3 million for Canadian investors and $5 million for U.S. & International investors.

We assemble concentrated portfolios – our top ten holdings typically represent between 25% to 45% of a portfolio. In this way, clients benefit from the ideas in which we have the highest conviction.

Our investment interests are directly aligned with those of our clients, as Gluskin Sheff’s management and employees are collectively the largest client of the Firm’s investment portfolios.

$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) would have grown to $9.3 million2 on August 31, 2009 versus $5.1 million for the S&P/TSX Total Return Index over the same period.

PERFORMANCE

Our success has often been linked to our $1 million invested in our Canadian Value long history of investing in underfollowed and under-appreciated small Portfolio in 1991 (its inception date) 2 and mid cap companies both in Canada would have grown to $9.3 million on August 31, 2009 versus $5.1 million for the and the U.S. S&P/TSX Total Return Index over the PORTFOLIO CONSTRUCTION same period. In terms of asset mix and portfolio $1 million usd invested in our U.S. construction, we offer a unique marriage Equity Portfolio in 1986 (its inception between our bottom-up security-specific date) would have grown to $10.8 million fundamental analysis and our top-down 2 usd on August 31, 2009 versus $8.4 macroeconomic view, with the noted million usd for the S&P 500 Total addition of David Rosenberg as Chief Return Index over the same period. Economist & Strategist.

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