David A.

Rosenberg October 13, 2010

Chief Economist & Strategist Economic Commentary
[email protected]
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
The risk-on trade is back with the equity market even more comfortable now that
QE2 is on its way after sifting through yesterday’s FOMC minutes. The fact that • While you were sleeping:
the risk-on trade is back
the Fed staffers, yet again, took a knife to the macro outlook did not even
with the market even more
register a yawn. So we have a market backdrop completely dependent on comfortable now that QE2
sentiment and psychology as the P/E multiple expands and at the same time a is on its way after sifting
market backdrop that has become unglued from economic reality. through yesterday’s FOMC
minutes
The Fed is so desperate that it is even contemplating measures that would • Some sector screens
attempt to boost inflation expectations — nice in theory, but in practice this may based on low correlations
be difficult. Totally experimental, but Mr. Market seems to be putting blind faith to U.S. growth, high
in the Fed as it did back in the fall of 2007. correlations to emerging
market growth, decent
As far as today’s market action, the key correlation of course is with the U.S. yield and attractive P/Es
dollar, which is heading back south, but at the same time, so are the yen and • Small business, small
Swiss franc — the other defensive currencies. The euro is bid as signs continue confidence level: the NFIB
to emerge that no more easing is coming out of the ECB — France’s inflation rate small business optimism
survey just came out and
rose to 1.8% in September from 1.6% on the back of the food complex. And, the
confidence is still at
emerging market currency complex is firm today as well — ditto for the recessionary levels
commodity currencies as the loonie and Aussie dollar continue on in their race
towards “par”. CDS spreads are tightening overseas as perceived corporate • What’s ahead in Q3
earnings season? The
default risks recede further.
consensus is looking for
24% YoY earnings growth
Meanwhile, in the global equity market, it is a literal sea of green right across the in the U.S.; revenues are
screen — back to six-month highs for the MSCI World Index. The other news that seen lagging behind once
lifted confidence was the trade report showing that China’s exports jumped 25% again; profit growth is
in September and Japanese machinery orders soared 10.1% in August (there slowing down, but
consensus estimates are
was also a 3.3% rebound in Australian consumer sentiment). The post-data
probably still too high
backup in JGB yields have been transmitted to other sovereign bond markets in
the wee hours of the morning.

The commodity sector is gaining ground with the U.S. dollar back in retreat
mode. Copper is testing 27-month highs, the entire food complex is rallying
again, and gold is just 0.4% shy of making a new all-time high. Oil is recovering
on the back of an increase in the IEA forecast for global demand (by 300,000
barrels per day for this year and next — to 86.9 million barrels per day, and
88.2mbd, respectively) as well as the news that China imported a record 23.3
million metric tons of crude last month.

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 13, 2010 – BREAKFAST WITH DAVE

The politics may well be turning more positive for the markets as well; we see
two developments that suggest as much. The White House said it is backing Bill Clinton is increasingly on
off from any plans to impose a moratorium on home foreclosures (what the his way towards being the
industry decides to do is its business). And, President Obama just lifted the Democrats’ “white knight”
ban on deepwater drilling. Bill Clinton is increasingly on his way towards being as election day approaches
the Democrats’ “white knight” as election day approaches (see page 5 of the (see page 5 of the FT) and
FT) and who knows how to move to the middle better than him. Who knows? who knows how to move to
If the President is already showing signs of flexibility and can manage to pull a
the middle better than him
few feathers out of Mr. Clinton’s cap, perhaps the Bush-era dividend, capital
gains and ‘high-income’ tax rates will see a post-2010 reprieve. For a
sentiment-driven market, this would likely be important.

A must-read today is Martin Wolf’s column on page 11 of the FT — Why

America is going to Win the Global Currency Battle. To wit:

“The global consequences are evident: the policy will raise prices
of long-term assets and encourage capital to flow into countries
with less expansionary monetary policies (such as Switzerland) or
higher returns (such as emerging economies). This is what is
happening. The Washington-based Institute for International
Finance forecasts net inflows of capital from abroad into
emerging economies of more than $800bn in 2010 and 2011. It
also forecasts massive intervention by recipients of this capital,
albeit at a falling rate.”

Also see The Currency Race That Everybody is Trying to Lose on page 25 for
why gold is likely going to make new higher highs. The Fed is pushing on a
string and is in a classic
The Fed is pushing on a string and is in a classic liquidity trap but the markets liquidity trap but the markets
love the prospect of more reserves flowing into risk assets even if the love the prospect of more
economy is left in the dust. In this respect, the quote of the day goes to reserves flowing into risk
former Dallas Fed President Mike McTeer on page B2 of the NYT regarding the assets even if the economy
move afoot to QE2 — “If you lead the horse to water and it won’t drink, just is left in the dust
keep adding water and maybe even spike it …” Yikes! This will not end well,
even if it is next to impossible to say when it does.

Page C1 of the WSJ runs with Fed Moves Viewed as Softening the Dollar. The
article posits that “Investors increasingly believe the U.S. is putting itself at
the forefront of the competitive devaluation race. That view is driven in part
by the Treasury’s increased pressure on China to allow its currency to rise
against the dollar, which would likely result in the dollar falling against a
range of other emerging market currencies.”

Since 1985, dollar-yen has sunk nearly 70% and yet the US has the same
bilateral deficit with Japan today as it had then. So why does everyone think
that a Chinese revaluation will necessarily clear out any perceived
imbalances? Maybe if U.S. policy encouraged thrift over asset-based
consumption growth, these trade imbalances would dissipate more quickly.

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October 13, 2010 – BREAKFAST WITH DAVE

And the front page of the WSJ has this as a lead article — Fed Chief Get Set to
Apply Lessons of Japan’s History. While there are differences, “the similarities While getting the asset mix
between the two economies are striking.” The article dusts off a speech that right is always extremely
Ben Bernanke gave over a decade ago on Japan’s policy paralysis and one of critical, so is getting the
his suggestions was to “cheapen the yen” as well as to “buy long-term debt”. sectors right within the
This certainly seems to be the current roadmap in the U.S.A. equity allocation

Finally, an article that truly resonates with us — from the front page of the NYT
(Across the U.S., a Long Recovery Looks Much Like a Recession). For how
long the equity market can become unglued from the real economy remains to
be seen, but there is little doubt in our mind that it is going to take years to
repair all the damage and absorb all the excess supply (of homes, office
buildings, plants and labour). The article is well worth a read, regardless of
your market view.

SOME SECTOR SCREENS

While getting the asset mix right is always extremely critical, so is getting the
sectors right within the equity allocation. With this in mind, what makes sense is
to own the sectors that have this combination of characteristics:
1. Low correlations to the sluggish U.S. economic growth profile.
2. High correlations to the stronger emerging market growth profile.
3. Comparable or better dividend yield than you can get in the bond market.
4. Below average P/E ratios in the search for relative value.
The sectors that stand out as possessing the best attributes after running
screens on the above-mentioned factors (for both Canada and the United
States) are Staples, Health Care and Energy, followed closely by utilities.
The sectors that screened poorly were Industrials, consumer discretionary
and financials.

SMALL BUSINESS, SMALL CONFIDENCE LEVEL

The National Federation of Independent Business (NFIB) survey came out for Despite the fractional
September and it was predictably soft — edging up fractionally to 89.0 from increase, small business
88.8 in August. To put that number in context, it was 92.9 in September 2008 sentiment in the U.S.
when Lehman collapsed; it was 96.3 on September 2001 when the terrorist remains at recessionary
attacks occurred; and it was 99.5 in September 1998 when the Fed was levels
forced to bail out LTCM and Russia defaulted.

This is a recessionary level; that is for sure. But as usual, the devil was in the
details:

• Hiring intentions fell from +1 in August to -3 in September. This is a 10-

month low.

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October 13, 2010 – BREAKFAST WITH DAVE

CHART 1: NO PLANS ON A HIRING SPREE FROM SMALL BUSINESSES

United States: National Federation of Independent Business Small Business
Optimism Survey: Percentage Planning to Increase Employment
(net, percent)
20

15

10

-5

-10
04 05 06 07 08 09 10
Source: Haver Analytics, Gluskin Sheff

• Pricing intentions, even with the spike in commodities, fell from +10 to +7 in
September, the lowest in nine months.
• Wage increase intentions fell from +6 to +3 in September, a three-month low.

CHART 2: SMALL BUSINESSES NOT LOOKING TO INCREASE WAGES

United States: National Federation of Independent Business Small Business
Optimism Survey: Percentage Planning to Raise Worker Compensation
(net, percent)
20

16

12

0
04 05 06 07 08 09 10
Source: Haver Analytics, Gluskin Sheff

• Those claiming that credit was hard to get rose from +12 to +14, the highest
in five months.

A lot of pundits are talking about reflation or inflation, but it is the small
business sector that has a strong say in the direction of pricing power. Only
4% cited inflation as a concern in September and just 3% cited labour costs.
At the same time, the weak sales outlook was the top concern for 30% of
small businesses, and 23% stated that taxes were on the top of the worry list.

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October 13, 2010 – BREAKFAST WITH DAVE

WHAT’S AHEAD IN Q3 EARNINGS SEASON? When profit margins are at a

• The consensus is looking for +24% YoY earnings growth. cycle high, we find that on
• Revenues are seen lagging behind once again, at +7%. average, profits invariably
end up lagging well behind
• Strip out financials and operating EPS growth is seen at a more modest
+18% (half the pace of the first half of the year). nominal GDP growth
• Profit growth is slowing down, but not collapsing. That said, consensus
estimates are probably still too high.

Two wild cards could be reduced guidance from the Tech and Transports
sectors — we say that because of the comments on these two sectors coming
out of the recent ISM survey:

Computer & Electronic Products: “Strategic customers reducing order

quantities.”

Transportation equipment: “Customers seem to be pulling back on orders. I

suspect that they are trying to reduce their inventory for the approaching year-
end.”

Going forward, here is the challenge. The consensus is still looking for $95-
plus on U.S. operating EPS growth for 2011, but at a time when profit margins
are at a cycle high, not a trough. There is a difference. At troughs in margins,
profits, on average, expand at six times the pace of nominal GDP growth in the
ensuing year. But when margins are at a cycle high, we find that on
average, profits invariably end up lagging well behind nominal GDP growth
and, in fact, decline in the next year by 3% on an average basis, and close
to 5% on a median basis. As a result, it may be more prudent at this juncture
to be valuing the equity market on $75 of S&P 500 operating earnings next
year than on $95. Slap on an appropriate multiple and you can see why an
underweight position still makes sense, speculative QE2 fervor
notwithstanding.

All we know is that in the aftermath of the very soft ISM and nonfarm payroll
reports for September, double-dip risks, as they pertain to the U.S. economy, In the aftermath of the very
have not exactly disappeared. So it would stand to reason that an equity soft ISM and nonfarm payroll
investor would rather own sectors that have low as opposed to high
reports for September,
double-dip risks, as they
correlations with the U.S. economy. The sectors with the highest
pertain to the U.S. economy,
correlations are industrials, financials and technology. The sectors with
have not exactly
the lowest correlations are health care, energy and utilities.
disappeared
What’s even better is that the first group has an average dividend yield of
1.2% while the latter is 3.5%. So not only does the latter group have lower
exposure to the uncertain U.S. business cycle, but it carries a 230 basis point
dividend yield premium. The latter group of more defensive sectors also has
an average earnings yield of 7% versus 5% for the former group of segments
more geared to the domestic economic backdrop.

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October 13, 2010 – BREAKFAST WITH DAVE

In our work, Energy and Health Care are among two of the most undervalued
equity sectors at the current time; Financials and Materials, two of the most Despite the positive
expensive. momentum and the “good
news” Canada story, the
As for the overall U.S. equity market, our propriety fair-value model moved risks for the Canadian dollar
down to 1,050 in the past month from 1,070, with regard to the S&P 500. from here, at least over the
The range is 1,000 to 1,120 so the index has moved above the top end of the near-term, seem to be pretty
band. This suggests an overvaluation of around 10% — the last time it was one-sided
this overvalued was late last year; the Shiller normalized P/E ratio is now
pointing towards a near-30% degree of overvaluation; a Tobin-Q model that
looks at replacement-historical costs indicates a 20% level of overvaluation.
In a nutshell, this market is no bargain at today’s prices. What stood out in
the past month was that the stock market surged even as analysts cut their
EPS forecasts, generating P/E expansion, presumably on QE2 hopes.

With respect to the TSX, our fair-value estimate also declined, to 10,785 in
the past month even as the market melted up — now about 16% overvalued
from where the market is trading today (range of 10,380 to 11,090). There
was a modest decline in earnings estimates, both trailing and forward. The
most undervalued sectors are a little different than in the U.S.A. — staples,
Tech and Telecom; Materials, Utilities and Financials are the most expensive.

In terms of the fixed-income market, our work still finds corporate bonds to be
attractively priced, on average, with BB rated bonds still the most
undervalued slice. Our main model incorporates BBB-rated product and it
suggests that we would still have 80bps of spread tightening to go before
hitting fair-value levels. The high yield market is better priced than investment
grade right now — that story has not changed.

The Canadian dollar is now 99 cents (U.S.) while our fair-value estimate is
stuck at 91.5 cents. The last time the loonie was this far overvalued was
back in the third quarter of 2008. No doubt it took an “event” (like a “black
swan”) to knock the loonie off its perch back then, but suffice it to say, it is
more vulnerable to downside surprises from here than it is susceptible to any
substantial upside potential. In other words, despite the positive momentum
and the “good news” Canada story, the risks for the Canadian dollar from here,
at least over the near-term, seem to be pretty one-sided.

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October 13, 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 June 30, 2010, the Firm managed We have strong and stable portfolio
assets of $5.5 billion. management, research and client service
teams. Aside from recent additions, our Our investment
Gluskin Sheff became a publicly traded
Portfolio Managers have been with the interests are directly
corporation on the Toronto Stock
Firm for a minimum of ten years and we
Exchange (symbol: GS) in May 2006 and aligned with those of
have attracted “best in class” talent at all
remains 54% owned by its senior our clients, as Gluskin
levels. Our performance results are those
management and employees. We have Sheff’s management and
of the team in place.
public company accountability and employees are
governance with a private company We have a strong history of insightful collectively the largest
commitment to innovation and service. bottom-up security selection based on client of the Firm’s
fundamental analysis.
Our investment interests are directly investment portfolios.
aligned with those of our clients, as For long equities, we look for companies
Gluskin Sheff’s management and with a history of long-term growth and
employees are collectively the largest stability, a proven track record,
$1 million invested in our
client of the Firm’s investment portfolios. shareholder-minded management and a
Canadian Value Portfolio
share price below our estimate of intrinsic
We offer a diverse platform of investment in 1991 (its inception
value. We look for the opposite in
strategies (Canadian and U.S. equities, date) would have grown to
equities that we sell short.
Alternative and Fixed Income) and $10.9 million2 on June 30,
investment styles (Value, Growth and For corporate bonds, we look for issuers
1 2010 versus $5.4 million
Income). with a margin of safety for the payment
for the S&P/TSX Total
of interest and principal, and yields which
The minimum investment required to Return Index over the
are attractive relative to the assessed
establish a client relationship with the same period.
credit risks involved.
Firm is $3 million for Canadian investors
and $5 million for U.S. & International We assemble concentrated portfolios —
investors. our top ten holdings typically represent
between 25% to 45% of a portfolio. In this
PERFORMANCE way, clients benefit from the ideas in
$1 million invested in our Canadian Value which we have the highest conviction.
Portfolio in 1991 (its inception date)
Our success has often been linked to our
would have grown to $10.9 million on
2

long history of investing in under-followed

June 30, 2010 versus $5.4 million for the
and under-appreciated small and mid cap
S&P/TSX Total Return Index over the
companies both in Canada and the U.S.
same period.
$1 million usd invested in our U.S. PORTFOLIO CONSTRUCTION
Equity Portfolio in 1986 (its inception In terms of asset mix and portfolio For further information,
date) would have grown to $10.9 million construction, we offer a unique marriage please contact
usd on June 30, 2010 versus $8.6 million
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usd for the S&P 500 Total Return Index fundamental analysis and our top-down
over the same period.
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Notes:
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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 7 of 8
October 13, 2010 – BREAKFAST WITH DAVE

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