David A.

Rosenberg January 6, 2010

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
Mixed action in the equity markets with Europe in the red column, though most
of Asia was up again (China was conspicuous by its absence in the EM rally — • While you were sleeping —
perhaps reflecting government efforts to curb the property bubble). mixed action in overseas
equity markets, again;
bonds are trading
Bonds are trading a bit defensively; however, for the third time in the past six defensively, again;
months we have seen the 10-year yield approach the 4.0% mark, which gets the economic data less than
bond bears very excited, only to then see yield reverse course and head down. stellar
• Employment indicators
On the FX market, the Yen is soft after the Fujii resignation (Japan’s Finance mixed in the U.S.
Minister) and the commodity currencies are rather solid. Oil and metals are firm
as well. The cold snap isn’t just sending energy prices higher but food prices as • We retain an income tilt
as a core part of the
well — OJ futures just hit a two-year high after surging 12% in the past two days investment strategy, and
(buy, Mortimer, buy!). in large part, this is a
secular trend
At the same time, some of the overnight data were less than stellar. European
• More bad news for the
producer prices deflated for the eleventh month in a row in November (-4.4%) real estate market in the
and industrial orders fell more than expected (-2.2% in October). We see that U.S. — pending home
China has taken over top spot as the world’s primary exporter, replacing sales plummet 16% in
Germany (see page A6 of the WSJ). And while everyone seems so concerned November
over the supply of government bonds, look at what is happening in the corporate • U.S. consumers hanging
market as issuers take advantage of the risk-taking frenzy — $23.5 billion of new in by a thread
paper was placed yesterday alone (Baa spreads have collapsed 50bps in just
• A brighter tone to the tech
the past month). capex data in the U.S.

Interestingly, when highlighting the risks for 2010 they often boil down to house
prices, commercial real estate defaults, mortgage foreclosures, employment,
geopolitical, sovereign credit ... but rarely, if ever, is China mentioned —
specifically as to how policymakers there would respond to a resurgence of
inflation and what the impact would be on global markets (if you don’t see the
connection, go back and see what caused the 416 point meltdown in the Dow
back on February 27, 2007). For more on this, see Prepare For Treacherous
Ride as Risks Multiply in China on page 20 of the FT. John Plender’s column on
page 20 of the FT on the China’s challenges ahead in rebalancing its economy is
also well worth a read.

EMPLOYMENT INDICATORS MIXED

The ADP report came in a tad worse than expected, at -84k for December — the
consensus was at -75k. But let’s look at the positives for a change.

• November was revised “up”, to -145k from -169k previously.

• The -75k print was the “lowest negative” since March 2008.
• The data reflected a “sequential improvement” for the ninth month in a row.

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
January 6, 2010 – BREAKFAST WITH DAVE

Still, it is amazing that jobs are being shed at this juncture of the cycle, then
again, contractions induced by credit collapses are completely different than It is amazing that jobs
those caused by garden-variety inflation pressures and excess inventories. are still being shed at
this juncture of the cycle
What this means for nonfarm payrolls is interesting because the ADP report has
been “worse” than the private payroll component of the NFP data for seven
months now, whereas it was reporting smaller declines with near consistency
over the prior seven months. The two data series don’t have to line up but we
did find that as December rolls around, the 12-month trailing gap is, on average
(in absolute terms) 120k.

As of November, ADP had counted 4.725 million private sector job declines for
2009; the nonfarm data counted 4.047 million. That is a gap of 678k. Let’s be
generous and assume that government adds 30k to December’s data — the
average of the past two months — and that the consensus is correct that private
payrolls will be down 30k (since the consensus for total payrolls is flat). That
would suggest that we would finish the year with a massive difference between
ADP and NFP private payrolls of 648k (this would be how much more job loss
was picked up in the ADP database) which is not only 5x as large as what is
typical but would be the largest gap to finish a year on record.

Maybe, just maybe, we will see: (i) downward revisions to October and November
since ADP job losses in those two months are still 148k larger than what the The U.S. Census hiring
payroll showed at last count; and/or (ii) that the consensus is way off base in process is in the works
calling for a flat NFP headline this Friday. There is one forecast out there calling and this “boost” is the
for down 100k. main reason why we
may start to see
Note that the U.S. Census hiring process is in the works and this “boost” is the renewed job growth in
primary reason why we may start to see renewed job growth in early 2010, but early 2010
this is already in the market (the Challenger data this morning flagged a 17,504
jump in hiring announcements which has not happened since July 2007) and
what investors will focus more on during this government hiring phase are: (i)
private payrolls, (ii) the private workweek, and (iii) the employment diffusion
index, for signs of any true underlying improvement in the labour market.

WE HIGHLIGHTED YESTERDAY THAT …

• What is normal is that every percentage point of nominal GDP growth
translates into 2.5 percentage points of profits growth.
• Most economic forecasters see nominal GDP growth at 4% for this year. But
strategists see, on average, 36% profit growth. But that 4% growth in nominal
GDP is only enough to boost profits by 10% if the normal relationship holds up.
To see such low nominal growth and such strong profit growth is a 1-in-50
event. Maybe the economist and strategist at the Wall Street research
houses should sit down with each other.
• We are called “bearish” because we see profit growth coming in at +10% for
the coming year. That is hardly bearish. On average, profits in any given year
typically rise 7%.

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January 6, 2010 – BREAKFAST WITH DAVE

• The challenge is what is currently being discounted. Market participants

seem to agree that we will see something close to $77 of operating EPS this We continue to view the
year. That would be a 36% increase from the 2009 level. equity market as being
expensive, though
• If the market is correct, then we are talking about a 15x forward P/E multiple, technicals could take
which is just a snick above the 30-year average of 14x. If we are correct that the major averages
operating EPS comes in at $62 this year, then the market is trading at over an higher near-term
18x P/E multiple, and that would represent roughly a 30% degree of
overvaluation.
• Of course, the market can stay overvalued for an extended period of time, but
as we saw in 1987, 1990, 2000 and 2007, overvalued markets are more
vulnerable to downside surprises than is the case with undervalued markets.
Risk is at least as important as reward.
• The consensus is wrong most of the time. When the consensus is too
optimistic on earnings heading into a given year, history shows that in that
year the S&P 500 is down, on average, by 4.5% (-10% on a median basis).
And when the consensus is too low and earnings surprise to the high side, in
those years we see the S&P 500 rally 14.3% (+13.6% median). Admittedly,
this did not work in 2009 when the consensus forecasts was at $77 EPS at
the start of the year and we finished somewhere near $56 — and despite that
near-30% miss the market still managed to rally 20%. Then again, we had
record P/E expansion as Fed and Treasury-induced liquidity fuelled a massive
runup in investor confidence — underscored by the VIX index, which started
2009 at 40 and closed the year at 20. Something tells us that it is not going
to be cut in half again so the prospect of further multiple expansion is close to
nil and the key will be if earnings live up to their lofty expectations.
• Never before — never — have we seen a 4% nominal GDP performance
translate into anything remotely close to a 30% earnings profile, let alone a
figure higher than that. There is no possible level of operating leverage that
will allow for that. If you are of the view that we will see double-digit nominal
GDP growth this year, then at least you would have a consistent story (though
one that Lewis Carroll would be proud of).
• We should add here that on a Case-Shiller real normalized earnings basis, the
S&P 500 is now trading at 20x, which is 25% above the historical average of
14x. At the bubble peak in October 2007, the overvaluation gap was 40%. So
the market is not nearly as pricey today as it was at the bubble peak, but it is
still very expensive nonetheless. Besides, as everyone laments the fact that
Treasuries only yield 3.8% (looking at the 10-year Treasury note), few pundits
seem to point out that the S&P 500 dividend yield just broke back below 2%
for the first time since late 2007.

We retain an income tilt as a core part of the investment strategy, and in large
part, this is a secular trend — even REITs, after a setback in 2008, managed to
post a +28.5% total return last year, outperforming the equity market handsomely.
We continue to view the equity market as being expensive, though technicals
could take the major averages higher near-term, as they already have.

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January 6, 2010 – BREAKFAST WITH DAVE

No doubt the economic news has been better of late, though housing is now
looking soft again, but there is now a whole lot of growth priced into equities, so
it has become a show-me situation. Perhaps this is best described in today’s
Short View on page 16 of the FT — “…the S&P is in a big rally within a bear
market, and trading momentum will likely take it further. But the S&P is not at
the start of a new bull market.” Our friends at Katana Capital expanded on a
table comparing the onset of the secular bull market in August 1982 to the
current backdrop as an illustration, and we took their efforts and extended it
even further below.

TABLE 1: WHY THIS IS NOT THE ONSET OF A NEW SECULAR BULL MARKET —
A COMPARISON WITH AUGUST 1982
United States 1982 2009
Fed funds rate 18% and only one way to go (down) 0% and only one way to go — up
10-year bond yield 15% and falling 3.8% and rising
Monetary base $170 billion and rising $2.2 trillion and stable to falling
Budget deficit-to-GDP ratio -3% and moving towards a surplus -10% and steady or falling from here
Household debt-to-personal
disposable income ratio 62% and rising 123% and falling
Inflation rate 10% and falling 0% and rising
Savings rate 10% and falling 4% and rising
Unemployment rate 10.8% and falling 10% and rising
Misery index At 16 and falling At 12 and rising
Labour force participation rate 64% and rising 65% and falling

Tax rates (highest marginal) 69% and falling 35% and rising

Union share of the job market 20% and falling 12% and rising

Global trade barriers High and falling Low and rising

Profit margins (room for
expansion?) 6.0% 10.0%
S&P 500 P/E ratio (1-year
trailing) 8.0x 20.0x
P/E ratio (10-year normalized in
real terms) 7.0x 23.0x

S&P 500 price-to-book ratio 1.0x 2.2x

S&P 500 dividend yield 6.0% 2.0%

Investor sentiment 10% bullish 88% bullish

UofM opinion on government
policy 80% and rising 80% and falling

Baby boomer population Median age is 25, peak spending and Median age is 52, retirement focus
investing years ahead (capital gains) ahead (capital preservation)
Source: Haver Analytics, Gluskin Sheff

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January 6, 2010 – BREAKFAST WITH DAVE

MORE BAD NEWS FOR HOUSING

U.S. pending home sales plunged 16% MoM in November, far below Imagine what happens
expectations and wiping out the gains over the past four months that had most to the real estate market
folks believing that a recovery was at hand. On a year-over-year basis, pending when all the stimulus
home sales are up 15.5%, which seems firm; however, part of this increase
are gone
reflects the 4% plunge in November 2008.

This is more evidence of how these government programs do more to disrupt the
data inflow than actually provide any lasting stimulus. As with Cash for Clunkers
(see below), all the housing tax credits have done is lump a lot of sales into
September and October — the demand was already filled because everyone
thought the program was going to expire. Imagine what happens to the real
estate market when the tax credit measure lapses and the Fed’s mortgage
buying subsides ends at the end of the first quarter.

As Chart 1 shows, the collapse in housing values has yet to fully mean revert
towards rental rates. To do so would imply another 10-15% decline in
residential real estate prices, which we view as a major cloud over the 2010
economic outlook (the same holds true on a home price-to-wage basis). A
decline of that magnitude would take the number of households who are under
water on their mortgage from 15 million (25% of the mortgage population) to 30
million (half).

CHART 1: HOME PRICE TO RENT RATIO HAS YET TO MEAN REVERT

United States: FHFA House Price Index Relative to CPI Rent
(ratio)

1.050

0.975

0.900

0.825

0.750

0.675
95 00 05

Source: Haver Analytics, Gluskin Sheff

CONSUMER HANGING IN BUT BY A THREAD

U.S. auto sales came in fractionally above expected, at 11.2 million units
annualized in December in the face of massive incentives. (It has come to our
attention that 20% of the December sales were in “fleet”, which is well above
average and what this means is that a large chunk of the improvement last month
is not going to show up in the retail sales report to be released on January 14).

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January 6, 2010 – BREAKFAST WITH DAVE

This is a near 3% gain over November’s tally, but as we said before, from June
1983 to September 2008, a number as low as this was unheard of.

This is the new normal — excitement over an 11 million print on auto sales. The
old normal was 16 million, by point of reference. Then again, just how many sales
do we really need when the roads are already populated with 250 million cars and
trucks in a country whose labour force is barely over 150 million?

What is very clear is that the Cash for Clunkers program pulled forward a lot of
demand because no matter how you slice it, auto sales volumes are still running
20% below the levels that prevailed during the peak in the program last summer.
And, in terms of staying focused on the big picture as opposed to the monthly
gyrations along the trendline, the reality is that 2009 was the worst year for the
auto industry since 1982, and domestic sales still closed the year down over 20%
even with the blip we saw in November-December. As an aside, GM is forecasting
an 11-12 million range on auto sales this year; Ford is calling for 11.5-12.5 million
… levels that would still be 25% below the “old normal”.

Meanwhile, the news is mixed but certainly not horrible as it was this time last year
when it concerns the retail sector who are much leaner. According to the
International Council of Shopping Centers (ICSC) survey, same-store sales rose 2.5%
in December from a year ago, above the 2% target (actual data come out tomorrow).

It looks like the complete picture for November-December was +1.0% but that
comes off a -5.6% trend in the comparable 2008 period, which was the worst in
over 40 years. But sales in the opening days of 2010 have been less than stellar
— the daily tracking by Gallup shows daily shopping down to two-month lows; sales
at +1.6% YoY thus far (early days yet, though) are running below plan of +2.1%.
The Redbook described the first week of the year as “mixed” and “promotional”.

Make no mistake the consumer is beset by a variety of headwinds.

• Mortgage rates have backed up nearly 50 basis points over the past month, to
stand at 5.14% for the 30-year.
• Oil prices have jumped nearly $10 a barrel since that time too.
• Consumer bankruptcies finished 2009 with a 32% surge. Believe it or not,
this is one reason why housing (at least until November) appeared to be
turning the corner … 40% of all the home sales in 2009 were foreclosures or
short sales.

The latest data points on the consumer have indeed been a tad better than
expected. Part of this boils down to aggressive seasonal factors in December and
part of it boils down to the natural noise in the data. The trend is still very much
towards saving, not discretionary spending, and unless you are overweight
consumer cyclicals in the portfolio, having the once free-wheeling American
consumer live within his/her means is actually a good thing. But as we said, it is
not good news for sectors hitched to the part of the budget that is discretionary —
for a real-life example have a look at Recession Fuels Shift from Private to Public
Schools on the front page of the USA Today.

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January 6, 2010 – BREAKFAST WITH DAVE

A BRIGHER TONE TO THE TECH CAPEX DATA

We received the factory order data yesterday for November and it showed a 1.1%
MoM gain, but what really stood out was the bounce in tech order books —
expanding 4.9%, the best result in nine months.

New orders for computers were particularly strong, rising 12.8% MoM, and the YoY
trend in tech orders is pointing north at the current time. As the latest Barron’s
2010 outlook revealed, this is the most over-owned sector — the consensus is
right 20% of the time … and this may well be one of those times!

CHART 2: TREND IN TECH ORDERS STILL BELOW ZERO,

BUT HEADED IN THE RIGHT DIRECTION
United States: Manufacturers’ New Orders: Computers & Electronic Products
(year-over-year percent change)

40

20

-20

-40
98 99 00 01 02 03 04 05 06 07 08 09

Source: Haver Analytics, Gluskin Sheff

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January 6, 2010 – 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 September 30, 2009, the Firm
managed assets of $5.0 billion.
Gluskin Sheff became a publicly traded
corporation on the Toronto Stock
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remains 65% owned by its senior
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Our investment interests are directly
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We offer a diverse platform of investment
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Alternative and Fixed Income) and
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1 September 30, 2009
Income).
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 which we have the highest conviction.
Portfolio in 1991 (its inception date)
would have grown to $15.5 million on
2
We have strong and stable portfolio
management, research and client service
teams. Aside from recent additions, our Our investment
Portfolio Managers have been with the interests are directly
Firm for a minimum of ten years and we
aligned with those of
have attracted “best in class” talent at all
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levels. Our performance results are those
Sheff’s management and
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employees are
We have a strong history of insightful collectively the largest
bottom-up security selection based on client of the Firm’s
fundamental analysis.
investment portfolios.
For long equities, we look for companies
with a history of long-term growth and
stability, a proven track record,
$1 million invested in our
Canadian Value Portfolio
share price below our estimate of intrinsic
in 1991 (its inception
value. We look for the opposite in
date) would have grown to
equities that we sell short.
$15.5 million2 on
For corporate bonds, we look for issuers
with a margin of safety for the payment
versus $9.7 million for the
of interest and principal, and yields which
S&P/TSX Total Return
are attractive relative to the assessed
Index over the same
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period.
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our top ten holdings typically represent
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way, clients benefit from the ideas in
Our success has often been linked to our

long history of investing in under-

September 30, 2009 versus $9.7 million
followed and under-appreciated small
for the S&P/TSX Total Return Index
and mid cap companies both in Canada
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and the U.S.
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usd on September 30, 2009 versus $8.7
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million usd for the S&P 500 Total between our bottom-up security-specific
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fundamental analysis and our top-down
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2. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses. Page 8 of 9
January 6, 2010 – BREAKFAST WITH DAVE
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