Breakfast With Dave June 19

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

June 19, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave — A Snapshot DAVE IS ON VACATION AFTER TODAY AND WILL JOIN YOU AGAIN FOR BREAKFAST ON JUNE 29. TILL THEN. WHILE YOU WERE SLEEPING Risk appetite picks up: Equities are firm in Europe and Asia today and U.S. futures are flashing green. In FX, the Yen is slipping and commodity currencies are firming again — essentially confirming the up-move in equities. Government bond yields are also higher, up one beep here and across the pond. Libor/OIS spreads are narrowing. On the data front, German PPI was flat in May and down 3.6% on a YoY basis, the steepest deflation rate in 22 years. Lower bond yields are a good thing: Courtesy of the bond vigilantes taking a respite, the rate on the 30-year fixed mortgage fell 21bps last week to 5.38%. Delinquency rates still rising sharply: This is not particularly the case in the U.S. multi-family sector where defaulted apartment loans backed by CMBS broke above 5.0% in May while the default rate for retail/lodging pierced the 3.0% threshold. WHERE ARE THE ROOTS FOR THE NEXT CYCLE? While many investors are consumed with the rapid expansion of the Fed’s balance sheet and money supply, the ongoing contraction of the household balance sheet is a far more pronounced event that renders deflationary risks the more predominant near-term risk. This may not be any more evident now than it was in the reflation days of early 2002 when government stimulus also ran rampant, but we believe that the second half of the year will have shown more defensive and income-oriented strategies to have carried the day as it did back then. Post-credit collapse and asset deflation cycles are always gripped with fragility; the intermittent beta-trades and flashy rallies only serve to tell us that nothing moves in a straight line. From our lens, the stock market is only really back to the levels of last October when Warren Buffet was telling everyone to buy equities in the op-ed section of the New York Times. The reality is that the rally really looks fatigued even with yesterday’s bounce — the S&P 500 has made no headway at all since the very beginning of May.

IN THIS ISSUE • It seems that it’s too much effort for the markets or for most economists to dig beneath the surface in most of these economic reports • Where are the roots for the next cycle? • Our thoughts on corporate bond spreads • A rudderless leader? Keep in mind that while the LEI was impressive, both months had a diffusion index of 70% • Philly cheese steak. Yes, the Philly Fed index improved dramatically in June, but beneath the veneer, only 30% of respondents stated that conditions improved • Market led by multiple. Forward P/E ratio for the S&P 500 is at 14.5x and trailing P/E has expanded from 17.0x to 23.3x now

THOUGHTS ON CORPORATE SPREADS Chart 1 is a bar chart of Baa corporate spreads comparing where we are (374bps) to where we were (611bps at the end of last year) as well as to other periods of intense economic, financial and geopolitical strains. To be sure, corporate spreads have come in a long way from their nearby crisis highs but looking at prior peaks around major events and economic downturns, it does appear as though there is still a lot of very bad news priced into the sector.

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June 19, 2009 – BREAKFAST WITH DAVE

CHART 1: CORPORATE SPREADS — WHERE THEY STACK UP AGAINST PRIOR PEAKS United States: Baa Corporate Spreads (basis points) 724

1932: Great Depression 381

1937-38: Relapse 1962: Cuban Missile Crisis

113

1970: Recession

315

1973: OPEC Embargo

221

1975: Recession/Inflation Scare

413 329

1980-81: Recession/Latam Crisis

377

1982: Penn Square Bank Failure 1987: Stock Market Collapse

268

1990-91: Recession/Real Estate Crisis

239

1995: Tequila Crisis

180

1997: Asian Crisis

175

1998: LTCM Crisis 2001: Tech Wreck 2001: 9/11 Terrorist Attacks 2002: Enron / WorldCom Crisis

277 306 353 390

2008: Credit Collapse Current

611 374

Source: Haver Analytics, Gluskin Sheff

MARKET LED BY MULTIPLE The notion that we had moved to Armageddon lows in equities does not seem to hold water. After all, the forward P/E multiple on the S&P 500 at the lows was 11.7x. That was not a multi-decade low or some massive standard-deviation figure — we were actually lower than that at the October 1990 lows when the multiple was 10.5x and frankly, coming off the 1987 collapse, the forward P/E had compressed to 9.8x. As it now stands, the multiple is back very close to where it was at the October 2007 market high when the multiple had expanded to 15.0x. The range on the forward P/E over the last quarter-century is between 9.8x and 21.8x (excluding the tech bubble), so at 14.5x currently, it is hardly the case that this market can be viewed as a bargain. On a trailing earnings basis, the P/E multiple has actually widened, from 17.0x at the lows to 23.3x currently, a huge multiple expansion. At this stage of the 2003 recovery, the multiple hardly expanded at all, earnings were driving the rebound; coming off the October 1990 lows, the multiple expansion four months into the rally was closer to 2x; and the powerful surge in the post-1982 recovery saw a 3x multiple point expansion at this juncture — not 6x!

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June 19, 2009 – BREAKFAST WITH DAVE

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June 19, 2009 – BREAKFAST WITH DAVE

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