David A.

Rosenberg September 21, 2009

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

5B4B3B2B1B0BMARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
Some profit-taking seems to be taking center stage with global equities losing
ground today, bonds modestly bid and the U.S. dollar rebounding from the abyss • While you were sleeping —
(have a look at European Commercial Property Owners Face Debt Time-Bomb some profit-taking
on page 17 of today’s FT and you start wondering whether the Eurozone is in overnight with global
even worse financial shape than the U.S.A.). This is actually the second day that equity markets and
commodities losing
the world MSCI index has slipped after a very flashy six-month rally that has
ground
taken equity values into overvalued terrain — and in the case of the U.S.A., into a
zone that is generally reserved for the third year of economic expansion as • It’s quite an active week
ahead — FOMC confab
opposed to the current government-induced tentative move out of recession.
and the G20 meeting, U.S.
treasury auction and U.S.
The commodity complex is losing ground today and gold has retreated back housing data released
below the $1,000/oz threshold (the IMF’s executive board just approved a sale
• The new frugality is a
of 403.3 metric tons at a value of about $13bln; and gold consumption in India
secular theme —
has plunged 38% YoY — see Gold ETFs Push Bars, Coins Aside on page C2 of the consumers are cutting
WSJ). Copper is responding to news that LME stockpiles have risen to four- back and scaling down
month highs — a respite is in order after prices doubled this year. Note that the
• Equity market est tres
Baltic Dry Index sank 4.5% last week (and off 45% from the early-June highs) expensif — the S&P 500 is
and as such may be signaling more near-term price declines in the commodity trading north of a 26x P/E
space. So, in our view, a healthy correction would be a welcome development. multiple
Oil is riding a three-day decline and seems stuck in a $69-72/bbl range.
• What the macro
landscape looks like when
It’s quite the active week ahead. We have the G20 meeting on September 24- the markets rally 60%
25 in Pittsburgh where investors will be watching for any clues over how global from the low
bank regulation in the future is going to look (executive pay curbs, de-linking
• Is Jim Grant the latest to
commercial and investment banking, more stringent capital adequacy rules, be drinking the Kool-Aid?
lower acceptable leverage ratios). We also have the FOMC meeting on
September 22-23 and the question is the extent to which the Fed sounds an
optimistic chord in the press statement and whether there will be a reference to
more mortgage purchases or whether the emphasis will be on exit strategies
from the unprecedented credit easing moves that have taken place.

Data-wise, it is a very light week but what’s coming out has the “housing label”
all over it: July FHFA home prices on Tuesday; August existing home sales on
Thursday; and new home sales on Friday (along with the final University of
Michigan sentiment data for September and August durable goods orders).
That Lennar stated that its 3Q loss doubled on sustained revenue losses (-42%
YoY) is one sign, at least, that not every slice of the real estate sector is
performing as well as everyone seems to think — only the low-end, really, which
is on life-support from the slate of government assistance programs.

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
September 21, 2009 – BREAKFAST WITH DAVE

On deck for the week ahead is a very active Treasury issuance calendar too —
the U.S. Treasury will auction off $112 billion of 2, 5 and 7-year notes (a record Foreign investors continue
for the combination of these maturities), breaking the record of $109bln in late to buy U.S. treasuries —
August (Bloomberg News runs with a nifty article on this today). For all the talk international investors
of a buyers’ strike, what we saw this year was elucidating. In the face of a 15% mopped up around 43% of
decline in the trade-weighed dollar, international investors actually stepped-up the gross new issues at
their buying of Treasury securities mopping up an estimated 43% of the gross auction time
new issues at auction time (compared with a 27% share this time last year).
China added $24 billion to its U.S. bond holdings in July — its holdings now stand
at over $800bln and buying activity is up 10% from a year ago.

For added reasons as to why bond yields have been so well behaved despite the
impressive rally in risk assets in the past six months, see Eager Fed Helps Keep
Treasury Rally Alive on page C1 of today’s WSJ, and the article on what
households are doing to their portfolio mix on C8 (As Confidence Rises, So Do
Inflows: Investors Remain Wary as Bond Mutual Funds Grab Lion’s Share of
Money). In the meantime, the IPO market is on fire — another sign that perhaps
the rally in equities may be a tad out of hand — five new issues are lined up for
the coming week (see article on page C2 of the WSJ).

THE NEW FRUGALITY IS A SECULAR THEME

U.S. consumers are cutting back, and where they are not cutting back, they are This new frugality theme is
scaling down. This new cycle is all about “getting small” and it is deflationary. For all about “getting small”
yet another in the litany of signs pointing in the direction of social change towards and it is deflationary, in
thrift, have a look at what is transpiring at the upper echelons of the income strata our view
— Now Even Millionaires See the Benefits of Budgeting on page B5 of the Saturday
NYT is a must read.

Not only are the rich trading down, but the article quotes a high net worth financial
advisor who said “many of our clients are very happy to be sitting on bond
portfolios and cash reserves.” And see the article on page 2 of the Sunday NYT —
Beauty Products Lose Some Appeal During Recession. According to the NPD
Research Group, total sales of department store beauty products are down 7%
from year-ago levels. Women are apparently opting for the “natural look” — “some
people are selectively replacing higher-priced items with cheaper products from
drug stores and discount stores.”

Speaking of women, they are coming back into the labour force in droves so as
to help underpin sagging family incomes — and this new demographic trend is
going to likely be a factor taking the unemployment rate to new highs. See Back
to the Grind: Recession Drives Women Who Left the Work Force to Return on
page B1 of the Saturday NYT.

Page 2 of 8
September 21, 2009 – BREAKFAST WITH DAVE

INCOMES UNDER PRESSURE

A just-released Bloomberg poll showed that only 8% of U.S. households intend to
Household income is under
raise their spending in the coming six months while over 30% intend to cut back.
pressure in what is the
The reason is obvious — incomes are under strain in what is the most
most underemployed
underemployed labour market in 70 years. Household income for those in the
labour market in 70 years
peak earning years of 45 to 54 years of age plunged $7,700 from 2000 to 2008
to stand at $64,349 (based on the new Census data). Only those 54 and older
have seen their incomes rise over the past four years as the aging but not yet
aged baby boomers re-enter the labour market in droves to garner the income
so as to recoup their lost net worth and allow them to at least maintain some
semblance of a comfortable retirement lifestyle.

When we say the most underemployed labour market since the 30s, we aren’t
mincing words. The unemployment rate hit 10% in 14 states and in D.C. in
August, and in California, it actually did reach a 70-year high of 12.2%.

EQUITY MARKET EST TRES EXPENSIF

The S&P 500 is trading north of a 26x P/E multiple on trailing operating
earnings and history shows that at these high valuation levels, the market
declines in the coming year 60% of the time.

All we know is that we have a trailing P/E multiple (operating earnings) on the
S&P 500 of 26.5x — a record eight multiple point expansion from the low over a Going back six decades,
six-month span. Take note that this is the highest P/E multiple since March history shows us that the
2002, which is right around the time that the bear market rally at that time (also market typically faces
premised on post-crisis V-shaped recovery hopes) began to roll over. It took a serious valuation
good year for the fundamental bottom in the market to be put in, and that was constraints once it breaks
heresy back then too. The P/E multiple on non-scrubbed reported earnings has above the 25x P/E
soared 60 points since March to 184x — not only a record but five times more multiple threshold
expensive than what we saw during the peak of the dotcom bubble a decade
ago (oh, but we forgot — write-downs don’t matter).

Going back over the last six decades, we know that the market typically faces
serious valuation constraints once it breaches the 25x P/E multiple threshold.
The average total return a year out for the S&P 500 is -0.3% and the median is
-6.2%. The total return is negative a year later 60% of the time, so when we say
that there is too much growth and too much risk embedded in the equity market
right now, we like to think that we have history on our side.

As for valuation, well let’s consider that from our lens, the S&P 500 is now
priced for $83 in operating EPS (we come to that conclusion by backing out the
earnings yield that would match the current inflation-adjusted Baa corporate
bond yield). That is nearly double from the most recent four-quarter trend. Not
only that, but the top-down estimates on operating EPS, for 2009 are $48.00 for
2009; $52.60 for 2010; $62.50 for 2011; and $81.00 for 2012.

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September 21, 2009 – BREAKFAST WITH DAVE

The bottom-up consensus forecasts only go to 2010 and even for this usually
bullish bunch operating EPS is seen at $73 for 2010, which means that $83 is How does the U.S. macro
likely a 2012 story according to them. Either way, the market is basically landscape look like when
discounting an earnings stream that even the consensus does not see for the markets rally 60% from
another two to three years. In other words, this is more than just a fully priced the low?
market at this point.

The S&P 500 is, in fact, deeply overvalued at this juncture. Imagine that six
Real GDP has expanded by
5.3%, on average
months after the depressed lows we have a situation where …

• The trailing price-earnings ratio on operating EPS is 26.5x

Profits are growing at 34%
• The trailing price-earnings ratio on reported EPS is 184.2x

• The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the
Employment has
market is trading as if it were at a peak for the cycle, not any longer near a rebounded by 2.1mln
trough.
• The price-to-book ratio is 2.3x. If you want undervalued, try August 1982 —
the onset of an 18-year secular bull market — when the S&P 500 bottomed Bank lending, on average,
after trading at a discount to book value.
is growing at a 16.5% pace

If you go to page 14 of the weekend FT, you will see a reference to some Street
research assessing market valuation using the Tobin Q — based on this ISM is usually at 58.9
yardstick, equities are currently overvalued by 40%.

WHAT THE MACRO LANDSCAPE LOOKS LIKE WHEN THE MARKETS RALLY And, on average,
60% FROM THE LOW consumer confidence is at
91.8
• GDP has expanded by 5.3%, on average (now just bottoming out)

• Corporate profits are growing at 34%, on average (ditto)

• Employment has rebounded by 2.1 mln (still declining)

• Bank lending rose an average of 16.5% (ditto)

• ISM is at 58.9, on average (now 52.9)

• Consumer Confidence (Conference Board) is at 91.8, on average (now 54.1)

IS JIM GRANT THE LATEST TO BE DRINKING THE KOOL-AID?

The Weekend Journal ran with an article by James Grant, which admittedly took
us by surprise (he is a true giant in the industry, as an aside) — From Bear to Bull
and in the article, he relies mostly on the thought process from two economic
think-tanks — Michael Darda from MKM Partners and the folks over at the
Economic Cycle Research Institute.

Page 4 of 8
September 21, 2009 – BREAKFAST WITH DAVE

We highly recommend this article for everyone to read to understand the other
side of the debate. But we have some major problems with the points being Frankly, it doesn’t really
made. matter what “leading
economists” are saying
1. Mr. Grant starts off by saying that “as if they really knew, leading economists because Mr. Market has
predict that recovery from our Great Recession will be plodding, gray and already moved to the
jobless.” Well, frankly, it doesn’t really matter what “leading economists” are bullish side of the debate
saying because Mr. Market has already moved to the bullish side of the
debate having expanded valuation metrics to a point that is consistent with
4% real GDP growth and a doubling in earnings, to $83 EPS, which even the
consensus does not expect to see until we are into 2012. We are more than
fully priced as it is for mid-cycle earnings.
2. Nowhere in Mr. Grant’s synopsis do the words “deleveraging” or “credit
contraction” show up. Yet, this is the cornerstone of the bearish
viewpoint. Attitudes towards homeownership, discretionary spending
and credit have changed, and the change is secular, not merely cyclical.
After all, didn’t consumers just see a record $20 billion of outstanding
credit evaporate in August?
3. Mr. Grant emphasizes (the Darda argument) how we had a huge bounce in
the economy after the worst point of the Great Depression (in fact, the
subtitle of the article contains: “The deeper the slump, the zippier the
recovery”). Well, we didn’t have the Great Depression this time around —
real GDP did not contract 25% but rather by 3.7%. We probably have to go
now and redefine what a massive slump is. But all we had in the mid-part
of the 1930s — between the worst point in 1932 to the 1937-38 relapse — To concentrate on the
was a statistical recovery, and nothing more than that. Nobody from that
wiggles in the U.S. GDP
era will recall that any year was particularly good — each one was just
different shades of pain and sacrifice. By the end of the decade, the data in the 1930s, no
unemployment rate was still 15%, the CPI was deflating at a 2% annual matter how large, totally
rate and the level of nominal GDP, as well as industrial production, still misses the point about
had yet to re-attain its 1929 peak. The equity market in 1941 was no what the decade was
higher than it was in 1933 (and long bond yields were heading below 2%) really about
and even a child knows that it was WWII that brought the economy out of
its malaise, not the seven years of New Deal stimulus.
So, to concentrate on the wiggles in the GDP data in the 1930s, no
matter how large, totally misses the point about what the decade was
really about, which was social change, a focus on family, less
discretionary spending, and a trend towards frugality that few market
pundits seem to comprehend. But the 1930s were the antithesis of the
1920s — not unlike what we are witnessing today. To concentrate on a
bungee jump that wasn’t even sustained is akin to focusing on the noise
around the trend-line as opposed to the trend-line itself.

Page 5 of 8
September 21, 2009 – BREAKFAST WITH DAVE

4. The very sexy argument about how all the government stimulus is going
to give the economy a really big lift — combined monetary and fiscal Yes, the massive
measures are worth 19.5% of GDP. This is viewed as a good thing, of government stimulus is
course, but nowhere in the analysis is there a comment about how this
there to act as a cushion,
“stimulus” is just there to cushion the blow and smooth the transition as
wide swaths of private sector credit vanish. We are at the point where but what it symbolizes is
85% of housing activity is still being supported by government an economy that is weak
interventions. Is this really desirable? According to BusinessWeek, it’s and a precarious financial
not just the FHA financing 40% of new mortgage originations but the sector
USDA is also allowing builders and lenders to take advantage of rural
mortgages that require no-money down and with 100% financing
through “a little-known loan program”.
Well, as with most bulls, this new era of state capitalism is a reason to
rejoice. But from our lens, what would be more noteworthy would be an
article explaining that the massive government incursion with all this
“stimulus” is actually more a reason to be concerned than be jubilant —
what it really symbolizes is an economy that is so sick that it continues to
require massive doses of medication.
It’s not what all the stimulus does that matters — of course, it is there to act as a
cushion — but it is what all the stimulus has come to symbolize. A fundamentally
weak economic backdrop and a precarious banking system that has government
guarantees to thank for its survival.

We noted last week 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. 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 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
Liberal Democratic Party (LDP) did in Japan for much of the 1990s.

Page 6 of 8
September 21, 2009 – BREAKFAST WITH DAVE

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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 worth private clients, we are dedicated to the
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As of June 30, 2009, the Firm managed
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September 21, 2009 – BREAKFAST WITH DAVE
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