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June 2010

SPROTT ASSET MANAGEMENT LP

Wither Green Shoots


By: Eric Sprott & David Franklin

With the summer now upon us, the “Sell in May and Go Away” adage has proven itself true once
again. The major market indexes are all turning downward, and while they haven’t dropped enough
yet to warrant panic, we certainly want to be positioned properly if this trend continues into the fall.
The market tea leaves are no longer sending mixed signals either – most of the new data is decidedly
bearish. So what happened to all the ‘green shoots’? What happened to the strong recovery the
market rally was promising?

Economic data released over the past two weeks have decimated any remaining belief in a lasting
economic recovery. Slowdowns are appearing in the US, Europe, Japan and even China. Auto sales,
housing starts, employment, consumer confidence, factory orders, consumer purchase intentions -
just about every aspect of the economy that can be measured, is showing decided weakness.

Of particular interest to us over the past year has been the GDP forecasts released by The Consumer
Metrics Institute in Colorado (“CMI”). CMI caught our attention with their real time tracking of consumer
retail sales data. Consumer spending represents 70% of GDP, and that spending can provide great
insight into the workings of the underlying economy. CMI’s retail sales data has identified a long,
negative contraction in the economy based on their data set for the last 180 days. This was confirmed
most notably in Walmart’s poor first quarter sales results when CFO Tom Schoewe stated, “More
than ever, our customers are living paycheck to paycheck.”1 If that sentiment applies to other large
retailers, it doesn’t bode well for 2010 GDP.

CMI also predicted 2010 Q1 GDP growth at 2.62% all the way back in November 2009. It took
nearly seven months for the actual US GDP data to eventually be released, but when it finally did
(after three revisions, no less) it turned out that CMI’s prediction was bang on. Interestingly, when
the real data came out, CMI founder Rick Davis noted that the inventory component underlying the
2.7% Q1 GDP growth figure had moved from 1.65% up to 1.88% – meaning that the bulk of GDP
growth, almost 66%, actually came from inventory swings rather than consumer demand. No wonder
factory orders fell out of bed this past week! With the re-stocking complete, there aren’t enough new
orders to clear the fresh inventory. And if two thirds of Q1 growth came from inventory swings (or
just plain re-stocking etc.), it makes us wonder what we can realistically expect from the next two
GDP announcements. CMI provided the following guidance for the balance of the year, stating that
“We expect GDP growth to be flat for the second quarter, but with inventory adjustment reversals
absolutely killing the reported ‘growth’ number just four days before the U.S. mid-term elections.” If
that turns out to be correct, it will be unfortunate timing for the elections.

1 Bustillo, Miguel (May 19, 2010) “Wal-Mart Same-Store Sales Fall” The Wall Street Journal. Retrieved on July 8, 2010 from:
http://online.wsj.com/article/SB10001424052748703957904575252092724864622.html?KEYWORDS=wal-mart+struggles+to+to+keep+shoppers
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June 2010

An important question to ask is whether the March ’09 rally was really justified at all. Were the green
shoots real? Or was the market just looking for a way to justify the effects of government-induced
‘easy money’? The stock market is supposed to be an efficient, forward-looking indicator after all
– and the rally that began in March ’09 was supposed to signal a robust recovery. So where’s the
recovery? From the time the term ‘green shoots’ was first uttered by Ben Bernanke on March 15,
2009, the S&P 500 rallied 36% to June 30, 2010 and by as much as 60% to April 26, 2010. If the
green shoots were really just the early indications of weeds, was the market wrong to appreciate so
dramatically?

There is little doubt that much of the stock market action during the past 12 months has defied
traditional market rules. Nowhere is this more evident to us than in the banking stocks. We’re still
scratching our heads on the whole sector. Readers may remember an article we wrote in November
2009 entitled “Don’t Bank on the Banks” in which we discussed the hazard of leverage in the banking
system. If you gauge our conclusions by what actually transpired in the banking sector as a whole,
we were essentially correct. Of the 986 bank holding companies in the US last year, a total of 980 of
them LOST MONEY.2 And that’s even after all the government bailouts the sector received. Hmmmm.
Robust banking recovery? Not a chance. However, the remaining six banks, all of which are “too big
to fail”, did manage to earn a combined $51 billion in 2009, sending their stocks soaring as a result.
So despite 980 out of 986 bank holding companies returning nothing but red, the sector actually fared
pretty well from a market perspective. Does this make any sense to you? Here we have an entire
sector that is essentially broken; where a mere handful have maintained profitability not from their
own strength but thanks to the taxpayers’ bailouts; and where the government is now aiming the most
powerful of their regulatory reforms – and the market decides to pile into their respective equities?

Chart A

Returns on Homebuilder Index vs. New Homes Sold


Indexed from 'Green Shoots' to June 30, 2010

220
The Dow Jones U.S. Select Home Construction Index
200
New One-Family Houses Sold (SAAR)

180

160

140

120

100

80
16/03/09 16/05/09 16/07/09 16/09/09 16/11/09 16/01/10 16/03/10 16/05/10 16/07/10

Source: Sprott Asset Management LP

2 Lenzner, Robert (June 3, 2010) “Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money” Forbes. Retrieved on July 8, 2010 from:
http://www.forbes.com/2010/06/03/goldman-sachs-citigroup-markets-lenzner-morgan-stanley_print.html

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June 2010

The banking sector isn’t the only equity space that confounds us – the housing stocks are as equally
absurd. Despite what you may have heard from your local real estate agent, the fundamentals for
US housing are looking dismal. Ever since the tax credits have rolled off, new home sales are now
running at 300,000 on a seasonally-adjusted annual rate (“SAAR”), representing a new all time low
this past May. For comparison, this is down from an all time high of 1,389,000 new home sales made
in July of 2004.3 Reading this, you may expect the home builder stocks to have performed poorly.
But no, not in this market! As you can see in Chart A, from the day that Bernanke first saw his ‘green
shoots’, the home builders index appreciated by 47% to June 30, 2010, peaking at 104% on April
23rd – all while new home sales were down 14% over the same time period on a SAAR basis.4 ‘The
Market is Always Right’, as they say, but it simply can’t be with regard to these stocks. The housing
‘green shoots’ were the product of government initiative, rather than true fundamental improvement,
and were thus short term in nature. Now that the government program has ended, the whole sector
looks poised to fall apart.

At the end of the day, nobody should be surprised by the recent economic data. The stock market rally
that began in March ’09 was driven by monetary phenomena rather than anything fundamental, and
based on data from CMI for 2010 it appears that we have already entered an economic contraction
phase. The market is now beginning to reflect the fact that the green shoots were actually just the
early signs of weeds, and it would suffice to say that virtually all the major world governments have
some serious gardening to do. The recent contractions don’t necessarily mean that we’ll experience a
repeat of 2008’s stock market performance in 2010, but it does suggest that investors should question
the real fundamentals underlying their investments, lest the market begins to trade on them again.

3 US New One Family Houses Sold Annual Total SAAR (Bloomberg: NHSLTOT)
4 As measured by the Dow Jones U.S. Select Home Construction Index (Bloomberg: DJSHMB)
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