David A.

Rosenberg September 17, 2009

Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
Not much to report in terms of data flow. Equities around the planet are bid yet
again as Asia reaches fresh 12-month highs. Bonds are flat in the U.S.A. but • While you were sleeping:
selling off overseas. The U.S. dollar is weak and that is helping maintain a not much to report in
positive tone to the gold price. Imagine that, bullion is north of $1,000/oz at a terms of economic data
time when the U.S. CPI is -1.5% YoY — imagine what gold will do if (when?) that flow, but equities around
the world are bid
inflation rate turns positive.
• No matter how we slice it,
As we discuss below, the incoming economic data in both the U.S. and Canada the incoming economic
have improved and for the most part bettering expectations. The dilemma is that data in Canada and the
U.S. have improved …
market pricing has moved far beyond the fundamentals. Despite the temptation
to jump into a “liquidity-induced” rally, and these rallies can often take you to • … but the problem is that
heights that you can never imagine we would get to, they cannot be sustained market pricing has moved
far beyond the
without a durable organic economic expansion. The problem is that the global
fundamentals
economy in general, and the U.S. economy in particular, is operating on so much
medication that it is difficult to conduct an appropriate examination of the patient • U.S. industrial production
at the current time. All we know is that the markets seem to have very rapidly now came in better than
expected in August …
priced in three years worth of recovery.
• U.S. housing data still look
NO MATTER HOW YOU SLICE IT, THE DATA FLOW IS IMPROVING soft, despite all the
(MODERATELY) assistance from Uncle
Sam
There definitely seems to be more momentum being built up in the economy (and
the markets) than we had been expecting for the current quarter and it now looks • U.S. CPI data for August
like a fourth quarter relapse in the economy or the markets is a likely scenario. was superb; core CPI
came in a tame 0.1% on
Our long-term views have not changed, but the equity market has moved beyond
the month
green shoots and is sinking its teeth into a better-than-expected slate of positive
data, including some upward revisions. Of that there is little doubt. Third quarter • Loonie likes the Canadian
GDP could easily come in near 3.5% annual rate and while a 4Q slowdown is to be data
expected, a move to zero or below now does not seem tenable. • Mr. Market is on steroids

The industrial production data was a case in point. The headline in August came
in at +0.8% MoM, as with retail sales, well above expected, and July was revised
up, to +1.0% from +0.5%. This is only two months worth of data after a string of
declines but the numbers did come in above our expectations, especially in view of
the weakness in the August nonfarm payroll report. Productivity must still be
booming to garner a 0.8% increase in production (+0.6% in manufacturing) with
payrolls down 63k and a stagnant workweek.

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Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net
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September 17, 2009 – BREAKFAST WITH DAVE

What caught our eye was that unlike July, not all of the growth in production was
due to the auto sector, though it posted a 5.5% bounce on top of the 20.1% U.S. economic data have
increase in July. Excluding auto, production rose 0.6% last month (after a 0.3% been coming in very
gain in July) and that sounds very impressive but a whole lot of that came out of strong …
a 1.6% surge in food & tobacco output — the sort of increase in this sector that
comes around every five years or so. It should be noted that outside of autos
and food/tobacco, manufacturing output was up 0.2%. That is an okay number
and not necessarily deserving of a huge market rally, but at least modestly
positive.

Outside of these two sectors, manufacturing activity was mixed to fractionally

better. Machinery output was up 0.8% on top of a 0.6% advance in July, which is
good news for ‘old economy’ capex. Production of materials rose 0.6% and this
was in addition to the 1.3% bounce in July, while mining rose 0.5% on the month
attesting to the strength in the resource sector.

But there were plenty of industries that did struggle in August. Production in the
defense/aerospace industry stagnated; ditto for construction supplies. Tech
posted a 0.5% decline in its first setback since May — computer production down
1.2%, semiconductors down 0.6% and telecom equipment was flat. Consumer
non-auto durables fell 1%.

Industry operating rates remain very low, but are off the bottom — rising from all
time lows of 65.1% in manufacturing in June to 66.1% in July to 66.6% in August. … But the big question is
The sectors that have seen the greatest improvement have been primary metals, how this is sustainable
autos, apparel, food/tobacco, chemical manufacturing, and mining. with the consumer not
joining the party
The big question is how it is that retail sales have been so firm (if you believe the
data) with consumer credit contracting at a record rate and the news yesterday
that real average weekly earnings fell 0.2%, and this key metric has been flat or
down each month this year.

HOUSING DATA STILL LOOK SOFT

The NAHB index also edged higher but by an uninspiring 1 point to 19 in
September. This was widely expected but it does pay to note that this 19 print,
in what supposedly is the hottest sector of the economy (housing, with all the
assistance from Uncle Sam), is actually still below the worst levels of the past
two recessions.

One also has to wonder what the implications are of the “sales expectations”
sub-index falling to 29 from 30 means (or last week’s 10.3% plunge in mortgage
applications for new purchases — down 34% from already depressed year-ago
levels) — especially in the context of all the government incursions into the real
estate market to prop it up.

Page 2 of 8
September 17, 2009 – BREAKFAST WITH DAVE

U.S. CPI DATA SUPERB

While the bond market sold off yesterday, one has to be encouraged by the CPI
Many sectors are having
data. The core was only +0.1% MoM for the second month in a row (actually,
trouble seeing much in the
August was +0.07%). Even adjusting for Cash-for-Clunkers, the core would be
way of any pricing power
0.16%, so still very tame. Many sectors are having trouble seeing much in the way
of any pricing power in the retail sector. The YoY headline inflation rate, even with
the recent boost from energy prices, is running at -1.5% YoY. And, the core index,
which excludes food and energy, is now down to +1.4% and within distance of
taking out the 2003 low of 1.1%.

Again, in terms of sectors with any pricing power, it was lean pickings, and those
that looked to have any pricing power seem to have been seasonal in nature.

• Air fares rose 1.6% in August on top of a 2.1% boost the month before.

• Hotels rose 0.5% and, believe it or not, are up in four of the past five months.

• Apparel was little changed but that followed two very positive months and
since May prices have strengthened at a 5.0% annual rate.
• Movie theatre prices jumped 1.4% and have now risen four months in a row.

• Delivery services (Fedex, UPS) jumped 3.3% and this came on the heels of a
0.5% increase the month before.
• Hospital services posted a respectable 0.5% gain as well last month.

But there were steep declines in many other areas too: Jewelry, video-audio
equipment, home improvement, appliances, furniture, sporting goods, apartment
rents, and autos. In other words, wide swaths of the discretionary or cyclical areas
of consumer spending continue to lose pricing power.

LOONIE LIKES THE CANADIAN DATA

The Canadian dollar should really like the headline and details of that
manufacturing report that was released yesterday. Not only were July shipments
up a resounding 5.5%, but this was on top of a 2.2% runup in June and it
transcended the auto sector revival as 15 of 21 industry groups posted gains.
Excluding autos, sales were up 2.1% as well.

MR. MARKET IS ON STEROIDS

Not much more to say. The S&P 500 is now up more than 60% from the lows,
which is truly amazing and kudos to those who called it. But the question is
whether the fundamentals will ever catch up to this level of valuation — usually
after a 60% rally, we are fully entrenched in the next business cycle. Never before
have we seen the stock market rise so much off a low over such a short time
period, and usually at this state, the economy has already created over one million
new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs
(as may as were lost in the entire 2001 recession).

Page 3 of 8
September 17, 2009 – BREAKFAST WITH DAVE

It is acknowledged by all the pundits that the recession is over, even though
we can see that only industrial production and maybe with the help of the Will the fundamentals ever
government, real sales, but employment and real income are still falling from catch up with the current
where we sit. So dating the end of the recession as the NBER did in late 2001 levels of valuation in the
is one thing just because industrial activity troughs, but it took several market?
quarters for income and employment to bottom back then, so we had a listless
recovery in 2002 and a stock market that did not really embark on a
sustainable rally until mid-2003. A recession coming to an end is one thing,
but sustainable market rallies require solid recoveries. The stock market right
now believes that we are going to see that V-shaped recovery, but we remain
skeptical since post-credit bubble collapses typically see consumer spending,
which is over 70% of GDP right now, sputter even as other line items, such as
government spending, kick into gear.

In any event, it’s not even worthwhile debating the economic outlook at this
juncture. It’s about how much good news is already being discounted in the equity
market, and believe it or not, there is more good news being priced in today than
there was bad news being discounted back at the March lows. This is an
overbought and overpriced equity market and we remain of the view that there is
too much risk and too much growth being discounted to be a full participant. In our view, this is an
overbought and overpriced
It is not apparent today, to be sure, but it will be — if not by the fourth quarter, then equity market
certainly by the first quarter of next year — that there is not going to be normal
recovery following what was an abnormal credit-induced recession. We say that
knowing how forgiving Mr. Market is today over any adverse data points, and how
giddily it is responding to positive news. We have preferred to express any pro-
cyclical views in the fixed-income market where corporate bonds provide better
income than a 2% dividend yield, better downside protection if there is a relapse,
and a more reasonable assessment of the economic climate that lies ahead.

Investors who are tempted to jump into equities should acknowledge that what we
have on our hands today is not a normal market.

By the time the U.S. stock market rallied 60% off the October 2002 lows, we were
into July 2005. We were into the third year of the expansion. Go back to the onset What we have on our
of the prior bull market in October 1990 — by the time we were up 60%, it was hands today is not a
January 1994! It took almost a year to accomplish this feat coming off the 1982 normal equity market
lows too and back then, we had lower interest rates, lower inflation, lower tax
rates, lower regulation and an eight-year uninterrupted economic expansion to
sink out teeth into. So we are witnessing something truly without precedent — a
60% surge off a low in six months. This didn’t even happen in the 1930s!

The counter-argument, of course, is that the market this time around is coming off
massively oversold lows. Not true. The market was far more oversold and the
internals were much more compelling at the 1982 and 1990 troughs. The
multiples on price-to-earnings and price-to-book, not to mention dividend yields,
were much more attractive at the other lows.

Page 4 of 8
September 17, 2009 – BREAKFAST WITH DAVE

No doubt we had a financial scare at the March trough, but valuation at the time
was priced for -2.5% real GDP growth and $50 EPS, which is hardly Armageddon Our overall fundamental
even if a bad outcome. And while it is true that the S&P 500 slid 60% from peak- views and our outlook for
to-trough, we have news for you — so did corporate earnings. 2010 have not changed at
all and neither has our
In any event, this is the same market that lost its marbles in 2007, hitting fresh all investment philosophy
time highs by October of that year with visions of new definitions of global liquidity,
and at the time it was pricing in 5.5% real economic growth for the coming year.
Instead, we had zero growth on average. Mr. Market is a discounting barometer to
be sure, but he is not always right.

To reiterate, while acknowledging the obvious, which is that there is more

momentum in the economy and the markets over the short-term than we had
thought would be the case. However, our overall fundamental views and our
outlook for 2010 have not changed at all and neither has our investment
philosophy. If the S&P 500 was hovering closer to 800 or 850 right now, we
could see the case for equities, but the market has simply moved too fast and is
way ahead of the fundamentals, even if they do turn positive. Understanding
that equities are a long duration asset, we have found over the years that
investors have shortened their time horizons, and while it has become
fashionable to price the market on an earnings stream three years out, the error
term around any profit projection that far out is extremely wide. All we know is
that as far as the coming year is concerned there is currently more room for
disappointment than there is for upside surprises.

There is too much growth priced into the market and equities remain highly risky.
Then again, this is a market that is “all in” on the V-shaped recovery view and it will
likely take some shockingly weak data points to shake this conviction. By and We must reiterate that
large, the data are coming in above consensus estimates and there could well be
there is too much priced
into the market and
enough of a spillover into 4Q to prevent a complete relapse, thought 2010
equities remain highly
remains a wild card. We also cannot underestimate the extent to which the
risky
government, having invoked multiple stimulus measures, from becoming even
more aggressive. We are hearing rumblings that not only will the $8,000 first-time
homebuyer tax credit be extended beyond the November 30 expiry date, but that
the cap will be raised significantly. Damn the torpedoes, full steam ahead —
there’s a mid-term election to fight in 2010.

Sentiment is clearly bullish, which normally would indicate an overbought market,

but as we said earlier, these are far from normal markets. According to the latest
Investors Intelligence poll, bulls command a 47.8% share of the respondents and
bears are at 24.4%. Only 27.8% are in the “correction” camp, which is startling
considering (i) how extended this rally is, and (ii) the time of year we are in.

Page 5 of 8
September 17, 2009 – BREAKFAST WITH DAVE

We noted yesterday 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, in our view. 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 economic 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 LDP did in Japan for much of the 1990s.

Page 6 of 8
September 17, 2009 – BREAKFAST WITH DAVE

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September 17, 2009 – BREAKFAST WITH DAVE
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