Lunch With Dave 100209

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

October 2, 2009 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave THUD, DUD AND CRUD There’s no other way to describe the U.S. employment report that was just released for September. And guess what? The rose-colored glass donning set of economists who have been talking about sequential improvement in the data and how “less negative” the employment numbers have become can’t say that after today (thank the good lord). That’s because at -263,000 on nonfarm payrolls, instead of the -175,000 print that was widely expected, we actually saw sequential deterioration for the first time since May as the August decline was 201,000 (though revised from -216,000; July was revised lower to -304,000 from -276,000). If you think that is bad, consider that the Household Survey showed a massive 785,000 plunge in September which again was sequential deterioration because the decline the month before was 392,000. We’ll see if the legions of bulls will add this in their post-payroll write-ups today, but the Household survey actually leads the labour market at true turning points in the business cycle – and employment on this score has now slid by 1.2 million in the past two months. These numbers far from validate the overwhelming consensus view that the recession has come to an end just because of one positive stimulus-crazed GDP print (didn’t we have that in 2008 too?); not to mention the fact that the last time we came off such a two-month falloff in Household employment was back in March when the stock market was testing fresh 12-year highs. Sustainability is the key and there can be no durable recovery without net job creation and organic wage growth. Both were lacking in today’s report – in fact, the combination of the workweek edging back down to retest the all-time low of 33.0 hours and the near-stagnation in hourly wages dragged the proxy for personal income down 0.2% (reads: in nominal terms) and the year-over-year trend is getting perilously close to deflation terrain at +0.7% from +0.8% in August and +1.2% in July.

IN THIS ISSUE • We finally could be in the long-awaited corrective phase in equities • There is a secular theme afoot which is the boomer drive for income • Is the recession really over? • For product-pushing Street economists and strategists alike, what matters at the margin is only when the ISM index is moving up -- not when it's moving down • The long-range outlook for the US dollar is poor but it does not mean that it will lose its reserve currency status any time in the next decade

There were absolutely no redeeming feature in the data, unless you want to conclude that a modest 2,000 decline in temp agency employment – widely considered a leading indicator – is good news. The diffusion index sank to 31.9 from 34.9 (and to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up – which is very disturbing when you consider all the government efforts to stem the tide last quarter from housing subsidies to cash-for-clunkers to mortgage modifications. Full-time employment collapsed 814,000 – and it is these jobs that ultimately drive confidence, income and spending. The number of permanent job losses jumped over 400,000 or by 5% last month as well.

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 2, 2009 – LUNCH WITH DAVE

If the labour force participation rate had not declined to 65.2% from 65.5%, the unemployment rate would have actually jumped to 10.3%; as if the actual uptick to 9.832% (to the third decimal place) from 9.657% was good news to begin with. The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings. It is so painfully obvious from the data, that what is lacking the most is new hiring, especially in the small business sector which accounts for half of the job creation in the United States. The average duration of unemployment rose to 26.2 month from 24.9 months in August; the median spiked to 17.3 months from 15.4. It is so difficult now to find a job that a record 36% of the ranks of the unemployed have been searching with futility now for at least six months.

The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings.

The U-6 measure of the unemployment rate, which the most inclusive definition of the labour force and takes into account the fact that we have a record 9 million people working part-time because they have been pushed off full-time payrolls, hit a new high of 17% in September from 16.8% in August. The gap between this rate and the ‘official’ rate of 9.8% is at a record of 7 percentage points. The historical norm is closer to 4 percentage points and so the concept of mean reversion – Bob Farrell’s first market rule to remember – suggests that the unemployment rate is going to be setting new highs for the post-WWII era before too long (the prior high was 10.8% in Nov-Dec 1982), so the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point. And just in time for the mid-term elections. The index of aggregate hours worked, which combines hours worked with the number of bodies at work, seemed to be carving out a bottom in July and August It was in fact a false bottom, because this critical ingredient of GDP fell 0.5% in September to stand at its lowest level in six years. For Q3, aggregate hours worked actually contracted at a 3% annual rate so basically, what is keeping the economy afloat, is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery – labour input at some point is going to have to kick in. Let’s just say that as far as the equity market is concerned, any time it can rally 60% from any low at the same time that employment craters 2.7 million, tells you that there is a lot of hope being priced in. Today’s report would suggest that ‘false hope’ is more appropriate. MARKET ACTION We finally could be in the long-awaited corrective phase in equities that will hopefully give us a chance to ultimately buy the market at more appropriate valuation measures. We have said 850 on the S&P 500 would be an interesting price point. Meanwhile, somebody is seeing something, somewhere, and it pays to note that change occurs at the margin. The CRB index has flatlined since June and the raw industrials have sliced below the 50-day moving average. The Baltic Dry index is behaving poorly and likely not all related to fresh shipping supply. Treasury yields out to the 30-year have broken down and the curve is flattening which is a possible harbinger of a renewed slowing in growth following the Q3 stimulus-led spurt. The VIX is also on the rise as the anti-risk trade Page 2 of 10

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moves back to center stage. And let’s not forget that China’s stock market, widely viewed as a bellweather, fell more than 6% in Q3 (even as the S&P and Dow surge 15%). Since this was a technically-driven market as opposed to a fundamentally-driven market, maybe we should be watching the technicals here for the S&P 500: •

1020 is the 50-day moving average and below that point we break the uptrend line from the March low.

•

990 to make a lower low during the uptrend since July.

•

Ultimate support at the July low is 869. Break that level, and …. (well, let’s just say it is not good).

Does anybody consider just how critical it is to have had the long bond yield slice below 4% to 3.95%? The yield curve is flattening big time and since midSeptember the long bond has rallied more than 30 basis points. That is amazing and it means that the bond market crowd smells a rat somewhere – as it did when it rallied like this as the stock market was making new highs in the summer of 2007. As an aside, the last time the long bond yield was at 3.95% was in late April … when the S&P 500 was sitting at 855. We should add that real interest rates – the bond market’s proxy for real growth -- as measured by the yield on 10-year TIPS is all the way back to 1.5% after hitting a peak of just over 2% in early July and again, the last time it was where it is today, the S&P 500 was 20% lower than it is today.

The bond market crowd smells a rat somewhere.

We realize that the positive tone in the Treasury market is a thorn in the side for the equity market bulls, but think of the bright side; at least the bond rally has allowed 30-year mortgage rates to drift back below 5% for the first time in a good four months. Back to the equity market for one minute. The data points above are meant to be seen as key technical levels that need to be taken out before we can actually call this a corrective phase. Keep in mind that we have seen no fewer than fifteen 2% or worse down-days for the S&P 500 since the lows posted in March and each time we did not see technical levels pierced to the downside and in fact, what we never did see was much in the way of any follow-through. So let’s keep our powder dry before we can start thinking of much more attractive valuation levels in order to put the dry powder to work! And for those that believe that the stock market is correct in its assertion that 4% GDP growth is coming our way in the coming year, not to mention a doubling in corporate earnings, perhaps a read of Meredith Whitney’s op-ed piece on page A19 of the WSJ would be worth a read for some sober second-thought (“The Credit Crunch Continues”). I also highly recommend the article by David Wessel on page A2 of yesterday’s WSJ (getting a U.S. newspaper in Winnipeg is no easy task) on the ongoing deleveraging course in the U.S. household sector (“The Downside of Reducing Debt”). We also wonder aloud how it could be that all the economists, from academia to government to the financial sector, are all so convinced that the recession is over at a time when state tax revenues are down a record 17% Page 3 of 10

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YoY. This is one consensus call that in the end may be dubbed ‘The Great Embarrassment’. MORE ON VALUATION We feel we’re in pretty good company on this view when we see the FT quote research showing that the S&P 500 is overvalued by 35% (and here we thought we were being “skunky” when we said it was overvalued by 20%-25%). This by the way is based on data using so-called “cyclically adjusted” P/E ratios (the ratios that Wall Street strategists love to deploy); the market is even more overpriced using the Tobin Q theory of looking at market value versus replacement value. We still marvel at the shills who believe that the market is fairly valued and that somehow it is not fair to compare how far the market has ballooned over the March lows since those lows were “artificial”. Excuse me. The 676 closing low on March 9th was any more of an egregiously oversold low than the October 9th/02 low of 776? Or the August 12th/82 low of 102 when the S&P 500 was trading at an 8x P/E multiple, a 6 1/2% dividend yield and below book value? It always appears to be an oversold low at the trough, with the benefit of perfect hindsight. But the stock market, at the lows, was merely pricing in reality, a -2.5 GDP growth trajectory which is exactly what we will see posted for 2009 when the books are closed for the year. The market was down 60% from the highs, but guess what? So were operating earnings. And reported “unscrubbed” profits tumbled 90%. To think we can have a 60% rally from the lows in six months and believe that somehow this is normal – please. By the time the market is up 60% from any low, it usually is up that amount in three years, not six months; and over 2 million jobs have been created. This is the first time the market has rallied this much with the economy shedding 2.5 million jobs.

To think we can have a 60% rally from the lows in six months and believe that somehow this is normal – please.

Welcome to the latest new paradigm – jobless prosperity. And whether you look at operating or reported earnings, trailing or forward, the S&P 500 today is trading at multiples that are higher than they were at the market peak in October 2007. So we’re not talking about pricing the market with ‘mid-cycle’ multiples – it is trading at ‘late-cycle’ multiples. WHO HAS BEEN DOING THE BUYING? We already ascertained earlier in the week that is hasn’t been Ma and Pa Kettle – in fact, the FT quotes data from TrimTabs showing that only $2.5 billion in net inflows has gone into U.S. equity funds and ETF’s since the March lows. Inflows into bond funds have been ten times as strong. We know that corporate insiders have been net sellers of size. And the buying power from short-covering subsided months ago. The answer, and this validated by the FT on page 16 of yesterday’s edition, are the hedge funds. And once they begin to see signs that a V-shaped recovery is about as real as Santa or the tooth fairy, watch out. Because there aren’t any other buyers out there that can be identified.

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And as we have said before, there is a secular theme afoot which is the boomer drive for income. Not just the TrimTabs data, and not just the hugely oversubscribed $8.8 billion sale of California short-term notes (1.25% - 1.5% yield), but this drive towards ‘safety and income at a reasonable price’ has driven tax-free bond yields to 40-year lows. So far this year, inflows into these funds have totalled a record $60 billion. Good story on this on page C8 of today’s WSJ. BULLISH SENTIMENT AT AN EXTREME? From a contrary perspective, it's not complicated. Bullish sentiment is running at an extremely high level -- too high, in fact, for an economy that is still on life support. The latest readings? Investors Intelligence shows 50.6% bulls, up from 46.7% a week ago. The bearshare is stuck at 23.5%, hardly budging over the past week. The AAII poll shows 44% bulls (up from 39%) and 35% bears (from 44.6%). A ‘D’ FOR DIVIDENDS Everyone focuses on price, but not enough on total return. And recall that 40% of the total return in the past was derived from dividend growth. The number of firms raising their dividend plunged 45% from a year ago in Q3 (191 of the 7,000 universe) in the worst third quarter on this basis on record (according to S&P). Meanwhile, 113 companies cut dividends, the most in 27 years.

The number of firms raising their dividend plunged 45% from a year ago in Q3

IS THE RECESSION REALLY OVER? If it is, then the recovery is missing two limbs -- as was the case with the aborted post-recession turnaround in 2002. While industrial production and real sales activity appears to have carved out bottoms, it is quite apparent that the other two ingredients in the recession call -- employment and real "organic" personal income have not. Indeed, it pays to note that real personal income excluding government transfers fell 0.3% in August to a new cycle low. As we saw in 2002, there is no V-shaped recovery that occurs without incomes rising (and a 26x trailing and 16x forward P/E ratio is discounting something that's pretty good). Now, nominal consumer spending did rise 1.3% in August and real (inflation adjusted) expenditures rose 0.9% -- thanks to the cash-for-clunkers program which incentivizes consumers to fund their outlays by dragging their savings rate down to 3% from 4%. This is Uncle Sam at his best trying to play around with Mother Nature -- because the natural course of events will keep the savings rate on a discernible uptrend, especially when one deploys a demographic overlay to the analysis. The government can step in sporadically as it just did, but it can't reverse the trend -- only briefly disrupt it. When we do the calculation, if households had not run down their savings flow by 120 billion dollars as they did in August as they were lured into the auto market, we have news for you -Page 5 of 10

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nominal consumer spending would have barely eked out a 0.1% advance and in real terms we would have seen a 0.2% contraction. Now put that in your pipe and smoke it! Finally, it looks like auto sales did beat the most feared estimates out there, but at 9.2 million (annualized) units in September, that represents a 35% slide from 14.2 million August (and 19% below July’s level). THIS IS TIED FOR THE SECOND WORST MONTH FOR AUTO SALES IN THE PAST 28 YEARS! At least we know what the U.S. consumer really looks like when it is off the medication administered by the administration. Look for Q4 to show flat GDP and contraction in real final sales. It’s otherwise known as 2002Q4 redux and remember what the stock market did that quarter (hint: broke to new cycle lows). HAS ISM PEAKED? And if it has, will the bullish Wall (and Bay) Street strategists change their views (and will their masters let them?). Strategist after strategist came into our offices ages ago with the doctrine that it didn't matter whether or not ISM was sub-50, just by rising, it meant that conditions in the industrial sector were improving even if still contracting. Well, it's amazing how many "don't worry, be happy" notices we got yesterday, for even if ISM did decline for the first time this year, from 52.9 to 52.6 in September, it is still signifying expansion in the manufacturing sector. Ostensibly, for product-pushing Street economists and strategists alike, what matters at the margin is only when the diffusion index is moving up -- not when it's moving down. Now, how are we sure that the ISM has very likely peaked (as auto production crests – it does indeed now look as though motor vehicle production, which had been the primary factor boosting output and the manufacturing surveys, has now been totally realigned with sales)? Well, because the best leading indicator for the index lies in two of the components -- orders which dropped to 60.8 from 64.9, and inventories which rose to 42.5 from 34.4. In other words, the orders/inventory ration tumbled to 1.43 from 1.89 in August. Folks, that is the largest one-month decline in the ISM orders/inventory ratio since December 1980! The ISM was 53 that month – the next month it went to 49.2 (is that in the market?) and seven months later, we were in the early stages of the famed double-dip recession (which nobody saw coming at the time). Food for thought. As for inflation, prices-paid dipped in September to 63.5 from 66 on the same day we see a +0.1% print on the August core PCE deflator, which took the YoY trend down yet again from 1.4% to 1.3% -- the lowest it has been in eight years. MIXED NEWS ON CONSTRUCTION Again, the economics community went wild over the news that U.S. Construction spending rose 0.8% in August. But if truth be told, July was revised sharply lower (to -1.1% from -0.2%) so the August LEVEL was actually below consensus Page 6 of 10

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estimates. Not only that, but the headline number was skewed by a 7.4% jump in home renovation which doesn't even show up in GDP. What did catch our eye was the 0.1% dip in non-residential construction (-10.5% YoY) which is an area of the economy that remains under duress. U.S. DOLLAR OUTLOOK The greenback got massively oversold recently and in a period where risk aversion sets in, it would be reasonable to expect it to rally given its strong liquidity characteristics. But the long-range outlook for the U.S. dollar is poor and this does not mean that it will lose its reserve currency status any time in the next decade. As Dennis Gartman pointed out in a brilliant speech he delivered at a conference that I also spoke at yesterday, a reserve currency can trade bearishly – the direction is not the definition of a reserve currency; a reserve currency is a currency that is easily tradable around the world. The U.S. dollar has been the world’s reserve currency – the primary means of payment for global trade and capital flows -- for the past quarter century even though a quarter century ago dollar-yen was Y270! As Dennis poignantly pointed out, the country that is the dominant military power in the world is always the country that enjoys the status of being the world’s reserve currency – and history bears that out from Spain to the Dutch to the British to America. And there is no doubt that the United States is still the world’s dominant military power; hence it retains the reserve currency status and the dollar being in a secular bear market has little to do with that.

The United States is still the world’s dominant military power; hence it retains the reserve currency status.

But what about beyond the next ten years? Well, the outlook is rather murky, and when you see the FT article from yesterday’s edition (page 3 – “Coming Out as a Military Power With Global Ambitions”) and read how China’s spending on military has “been growing at double-digit rates for years now”, especially its air power and navy capabilities, it is quite a shock to say the least. It never ever has paid in the past century to write off the ingenuity and might of the United States, but we may look back a decade or two down the road and view what is happening today as the first signposts that the sun is setting on the hegemony as has been the case with so many other dominant powers in the past. To be sure, the fiscal might of the United States has completely eroded as years of pork-barrel overspending, insufficient resources to deal with a dramatic rise in dependency ratios in the near future, and decisions to cut taxes while fighting a prolonged war on terrorisms, have seriously jeopardized America’s financial, economic and military dominance. The fact that the current Administration is trying to combat a business cycle with ‘cash for clunkers’ and housing subsidies (at a time when the tax system already hugely favours homeownership as it is) shows that fiscal short-termism reigns and that it is completely bereft of ideas of how to plan for the long-term with regards to enhanced capital formation, skills and productivity, and sustainable job creation. Dennis believes that beyond the next decade, the Chinese renmimibi will be the unit to challenge the U.S. dollar for reserve currency status. And he is the expert when it comes to the foreign exchange market. As an aside, we both agreed Page 7 of 10

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that when it comes to politics, the United States seems to the only major country shifting its economic policies to the ‘left’. Say what you will about Europe, but the Merkel victory, coupled with strong leaders like Sarkozy and Berlusconi; the fact that the Tories will likely soon take over in the UK; not to mention the shifts in Japan and the success of the Conservatives in Ottawa to sustain repeated attempts at non-confidence motions, all stand in contrast to the real lack of “change” in the United States where fiscal policy is dominated by old-school Keynesian beliefs that you can resurrect a credit cycle via short-term populist measures. The mainstream economists in the press called ‘cash for clunkers’ a success, but as we see what sales did in September, all the plan did was distort the quarterly pattern of spending in the economy and little else, to colossal taxpayer waste. And let’s just finish off by saying that if there is a shred of truth in what Karl Rove had to say in yesterday’s op-ed piece in the WSJ (“Obama Can’t Outsource Afghanistan”), then gold is likely going to go much, much higher than $1,000 an ounce. That’s the currency we prefer.

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