Breakfast With Dave 103009

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

October 30, 2009 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING Not much in the way of follow-through from yesterday’s whippy market gains in the U.S.A. True, Asian equities are up 1.5% for the day, but down 2.6% for the week and we couldn’t help but notice that the key cyclical Korean Kospi index dipped 0.2% today, which thereby provides some non-confirmation to the rally on the continent. Europe is quite mixed. Bonds are rallying just about everywhere. The U.S. dollar is a tad softer after testing but failing to pierce the 50-day moving average in the latest mini-countertrend-rally. On the data front, believe it or not, Japan provided the sole piece of good news with the unemployment rate dropping in September, to 5.3% from 5.5% instead of rising to 5.6% as was generally expected. The data out of Europe was horrible with retail sales (volumes) down 0.5% MoM in Germany in August after a 1.8% slide in July — the consensus was at +1.0%, so this was indeed quite the downside shocker. In addition, German wages in Q2 were down 1.2% YoY. We also saw Spain’s producer price index deflate 0.3% MoM and down 8.1% on a YoY basis. The EU unemployment rate ticked up, to 9.7%, in September from 9.6% in August as well. Even in Japan, the CPI was down 2.2% YoY again in September even with the nascent improvement in the labour market (and midOctober preliminary figures show that consumer prices in Tokyo have declined 2.4% YoY, and this compares to a -2.1% trend in September). Despite all of the global stimulus — a net 3.4% of GDP according to the OECD — pockets of deflation are apparent almost everywhere. EARNINGS SEASON – LESS THAN MEETS THE EYE This is still a negative profit cycle. Today’s WSJ runs with an article that echoes some of the sentiments we have been sharing with our readership for the past while. The mantra that 80% of S&P 500 companies are beating low-balled estimates rings hollow because when you go back a year ago, the consensus for third-quarter earnings was at +28% YoY and by September of this year, that view “flipped” to an expected 7.5% drop. On an absolute basis—compared with last year’s third quarter — corporate earnings are poised to fall for a ninth straight quarter, a record losing streak.

IN THIS ISSUE • While you were sleeping — overseas equity market were mixed; bonds rallying just about everywhere; Japan reports a drop in its jobless rate • U.S. earnings season less than meets the eye — this is still a negative profit cycle • Demand for U.S. bonds still running high — the U.S. Treasury offered $123bln in bonds this week and total bid came in at $372bln • Producer prices in Canada confirms deflationary trend • Initial jobless claims in the U.S. still uncomfortably high • U.S. Q3 real GDP — absolutely nothing to get excited about

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 30, 2009 – BREAKFAST WITH DAVE

More than 60% of the S&P 500 companies have reported, and while most have beaten estimates, total profits, according to the article, are still down 4.1% versus expectations. Moreover, earnings are down 15.1% from last year’s third quarter. The optimistic view is that the string of quarterly YoY declines will be broken in Q4, but let’s get a grip because that says more about last year’s fourth quarter when the S&P 500's aggregate loss per share was an epic $23.25, on an as-reported basis. Not only was last year’s fourth quarter the first time these big companies as a whole lost money, they lost more in those three months than they ever made in any other quarter.

This week’s U.S. Treasury note auctions went reasonably well for a country running up a massive fiscal stimulus

DEMAND FOR U.S. BONDS STILL RUNNING HIGH Throughout this week, the U.S. Treasury note auctions went reasonably well for a country running up a massive fiscal stimulus. Could be that “Say’s Law” of supply creating its own demand is coming to fruition? The bid-cover ratio for the 5-year note of 2.63 was very good compared to the average of 2.35 for the prior four auctions. The government sold a record $123 billion in notes this week in four auctions. Each was heavily oversubscribed, drawing in a total of $372.4 billion in bids, more than three times the offered amount. Meanwhile, on the retail investor side, net inflows into taxable bond funds last week totaled $11.28 billion, on top of $8.8 billion the week before. While it is hardly the case that private clients are abandoning the equity market — buying a net $1.22 billion — it is a trickle next to the deliberate asset allocation decision being made in favour of fixed-income securities. Remember, U.S. households have 25% of their assets in stocks; less than 7% in bonds. If Bob Farrell’s rule number one on mean reversion plays out, look for fixed-income securities to remain in a secular bull market for some time to come. PRODUCER PRICES IN CANADA CONFIRM DEFLATIONARY TREND Canada’s industrial product price index (IPPI), which is similar to the U.S.’s producer product index (PPI), surprised to the down side, falling 0.5% in September versus market expectations of a 0.2% decrease. Since May of this year, the month-over-month trend in IPPI has been very volatile, going up one month then reversing course the next month, so it is difficult to find a trend with these monthly gyrations. Of the 21 major groups, over 85% were either down or flat on the month and a measly 15% (or just three groups) managed to eke out an increase. Again, this attests to our deflationary and hence income-heavy tilt to our investment strategy.

Producer prices in Canada still in deflation mode — this plays into our deflationary and hence income-heavy tilt to our investment strategy

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CHART 1: CANADA’S PRODUCER PRICES STILL IN DEFLATION MODE Canada: Industrial Produce Price Index (year-over-year percent change) 22.5

15.0

7.5

0.0

-7.5 60

65

70

75

80

85

90

95

00

05

Source: Haver Analytics, Gluskin Sheff

On a year-over-year basis, IPPI remains deep in deflation territory, down a nearrecord 6.1% in September. Excluding the effects of energy, which declined 2.6% in September, IPPI was down 0.3% -- the sixth consecutive monthly decline. Year-over-year the trend in IPPI, excluding energy, is at -2.1%, just a slight improvement from the -2.4% pace in August. Every stage of Canadian production is still in deflation mode — the raw materials purchase index down -21.4% YoY; prices for intermediate goods down 8.5% YoY – the ninth decline in a row, and finished goods are deflating at a 1.9% YoY rate.

Initial jobless claims remain very high, at 530k; however, the stock market is trading at valuation levels that is consistent with claims below 400k

The strong Canadian dollar is playing a supporting but not a dominant role here in terms of compounding this deflationary trend. As the Bank of Canada said in its latest policy announcement “persistent strength in the Canadian dollar” is going to “slow growth and subdue inflation pressures” and that seems to be the case. For September, the Loonie was up 0.6% versus the U.S., according to Statistics Canada, if the CAD remained unchanged, the IPPI would have declined 0.4% instead of sliding 0.5%. CLAIMS STILL UNCOMFORTABLY HIGH Yet again, U.S. initial jobless claims came in above expected, at 530k as of the October 24th week (from 531k the week before and 485k a year ago when the economy was only 12 months in recession). Back in the September payroll survey period, claims were closer to 550k so the current number should be consistent with employment declines of around 200k. The stock market, meanwhile, is trading at valuation levels that would ordinarily be consistent with claims well below 400k, just to put the latest number into perspective. Not only that, but just consider that the peak in the 2001 recession, right after 9-11, in jobless claims, was 517k. We are still 13k north of the worst print we ever saw in the last recession — that is quite amazing. The big difference is that the bottom in the S&P 500 was still a year away at that point, as opposed to (allegedly) being seven months behind us.

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October 30, 2009 – BREAKFAST WITH DAVE

What doesn’t seem to make the headlines is that initial jobless claims have now been above 500k for 42 consecutive weeks. The only time we had a more prolonged period of labour market angst based on this measure was back in the 1982 down-cycle, when claims were above 500k for 48 straight weeks. We are seven weeks away from a new record, and not one to be proud of. The difference of course is that back then, all the government had to do was break the back of inflation, and then we were off to the races. The median age of the boomer was 25, not 52; household balance sheets were expanding, not shrinking; credit growth was accelerating, not contracting; the labour force participation rates were rising, not falling; and government regulation was receding, not increasing. And, 1982 represented the onset of a secular 18-year bull market; 2009 represents the mid-point of a secular bear market.

In fact, initial jobless claims have been above 500k for 42 consecutive weeks, only seven weeks away from hitting a new record

U.S. Q3 REAL GDP — ABSOLUTELY NOTHING TO GET EXCITED ABOUT Never before did a gap between a 3.2% consensus GDP forecast and an actual print of 3.5% manage to elicit so much excitement in the equity market. It just goes to show how speculative the stock market has become. The question is why it is that the economy couldn’t do even better?

If not for all the government stimulus, real GDP in Q3 would have stagnated

Historically, the auto sector adds 0.1 percentage point or 0.2 percentage point to any given GDP report. In the third quarter, courtesy of cash-for-clunkers, the sector added 1.7 percentage points to the headline figure, which is less a than 1-in-10 event in terms of probabilities. Tack on the rebound in housing and government spending and the areas of GDP that received the most medication from public sector stimulus contributed almost all of the growth in the economy. You read this right. If not for all the government incursion into the economy in Q3, real GDP basically would have stagnated. Because of the housing and auto subsidies, the personal savings rate plunged to 3.3% in Q3 from 4.9% in Q2 — in the past quarter-century, there have been only four other times that the savings rate went down so much in one quarter. If not for that plunge in savings, real GDP actually would have contracted fractionally last quarter. The entire GDP growth was funded by a rundown in the savings rate that occurs less than 5% of the time. Moreover, what is normal in that first positive post-recession GDP release is a 5% annual rate of growth. That puts 3.5% in Q3 into a certain perspective, especially when you consider the massive amount of stimulus that underpinned the latest batch of data. The parts of the economy that did not receive government support didn’t fare too well in the third quarter. For example, total business spending (on structures, equipment and machinery) actually contracted at a 2.1% annual rate — the fifth decline in a row. State and local government spending also fell at a 1.1% annual rate. Since there was no cash-for-clothing program, spending on apparel slipped at a 1.5% annual rate. The economists had all been talking about an inventory cycle taking hold and yet there was an additional $130 billion of de-stocking in the third quarter.

What is normal in this first positive postrecession GDP release is a 5% annual rate of growth, not 3.5%

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October 30, 2009 – BREAKFAST WITH DAVE

The question has to be asked, if companies, both non-financial and financial, are big believers in this new post-recession V-shaped recovery that seems to have the hedge funds and most strategists excited, why are companies still cutting back in capital expenditures and inventories and why are banks still cutting back on lending at an unprecedented 15% annual rate.

We believe that the big risk for the U.S. going into Q4 is a renewed contraction in real final sales

While it seems very flashy, 3.5% growth is far from a trend-setter. Let’s go back to Japan. Since 1990, it has enjoyed no fewer than 19 of these 3.5%-or-better GDP growth quarters. That is almost 25% of the time, by the way. And we know with hindsight that this was noise around the fundamental downtrend because the Japanese economy has experienced four recessions and the equity market is down more than 70% from the peak. What is important for the future is whether the U.S. economy can manage to sustain that 3.5% growth performance in the absence of ongoing massive government stimulus. In other words, it may be a little early to uncork the champagne. From our lens, the big risk going into Q4 is a renewed contraction in real final sales. That is not priced into the various asset classes right now.

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October 30, 2009 – BREAKFAST WITH DAVE

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.

PERFORMANCE $1 million invested in our Canadian Value Portfolio in 1991 (its inception date) 2 would have grown to $15.5 million on September 30, 2009 versus $9.7 million for the S&P/TSX Total Return Index over the same period. $1 million usd invested in our U.S. Equity Portfolio in 1986 (its inception date) would have grown to $11.2 million 2 usd on September 30, 2009 versus $8.7 million usd for the S&P 500 Total Return Index over the same period. Notes:

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 $15.5 million2 on September 30, 2009 versus $9.7 million for the S&P/TSX Total Return Index over the same period.

Our success has often been linked to our long history of investing in underfollowed and under-appreciated small and mid cap companies both in Canada and the U.S.

PORTFOLIO CONSTRUCTION In terms of asset mix and portfolio construction, we offer a unique marriage between our bottom-up security-specific fundamental analysis and our top-down macroeconomic view, with the noted addition of David Rosenberg as Chief Economist & Strategist.

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