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Breakfast With Dave 072010

Breakfast With Dave 072010

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Published by Tikhon Bernstam

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Published by: Tikhon Bernstam on Jul 20, 2010
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David A. RosenbergJuly 20, 2010
 Chief Economist & Strategist Economic Commentarydrosenberg@gluskinsheff.com+ 1 416 681 8919
Breakfast with Dave
Gregory Zuckerman at the Wall Street Journal just published a Q&A on themarket and the macro outlook, featuring me alongside James Paulsen, Chief Investment Strategist at Wells Capital Management, whom I like a lot, butbasically disagree with 99% of his views. Mr. Zuckerman only had so muchspace and while he did a great editing job, what I thought I would do is passbelow the full-fledged responses from my end. Enjoy!
Where is the market headed the rest of this year and over the next 12-18 months?
The market, like life and the seasons, moves in cycles — 16 to 18 year cycles, infact. Sadly, this secular down-phase in the equity market began in 2000 when the major averages hit their peak in real terms, and so the best we can say is that we are probably 60% of the way into it. This by no means suggests that wecannot get periodic rallies along the way, but in a secular bear market, theserallies are to be rented, not owned.In contrast, corrections in a secular bull market, as we saw in 1987 (as scary asit was) are opportunities to build long-term positions at more attractive pricing.In secular bear markets, the indices do hit new lows during the recessions (
2002, 2009), when they occur; in secular bull markets, you do not make newlows — they are just corrections (
1987, 1990, 1994, 1998).The market is not as cheap as the pundits, who rely on year-ahead EPSestimates, deem it to be. When one incorporates cyclically-adjusted corporateearnings in ‘real’ terms, equities are still roughly 20% overvalued even after therecent correction.More fundamentally, it would seem reasonable to expect that the equity marketwill trade down to a valuation level that is historically commensurate with theend of secular bear markets. This would typically mean no higher than a price-earnings multiple of 10x and at least a 5% dividend yield on the S&P 500. So,we very likely have quite a long way to go on the downside.But it will not be a straight line and there will be intermittent rallies, as weexperienced a year ago April; however, not even that 80% bounce off the lowsmanaged to violate any of the long-term trend lines, which continue to portray aprimary bear market, not unlike what we endured from 1966 to 1982. Back then the principal cause was an inflationary spiral; this time it is a deflationarydebt deleveraging that is the root cause. Within the next 12 to 18 months, I cansee the S&P 500 breaking back below 900, and a substantial test of the March2009 lows cannot be ruled out.
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 highestlevel of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports
visit www.gluskinsheff.com
A meat-grinder market: typically, what happensafter a once-in-a-generation-type declineare powerful rebounds, butit never moves in a straightline
Tough slog foremployment: a survey byAccenture showed thatbusinesses in the U.S. donot plan to restore theirworkforce to pre-recessionlevels anytime soon
The roof collapses on U.S.housing: the NAHBhousing market indexcaved in again in July
The U.S. equity market isstill overvalued, according  to the latest Shiller P/Eratio reading 
What could happen thatwould turn you into abear/bull?
How will the U.S. mid-termelection affect stocks, if atall? Tax rates on incomeand capital are going upnext year, and gridlock willnot give us strong leadership — hardlypositives for the economicor market outlook
An interview with the Bear:Gregory Zuckerman at theWall Street Journal justpublished a Q&A on themarket and the macrooutlook, featuring mealongside James Paulsen,at Wells CapitalManagement, whom I likea lot, but basicallydisagree with 99% of hisviews
July 20, 2010
 What about the outlook for the U.S. and global economy?
I strongly believe that the economic recovery phase is behind us. Even if wemanage to avert a double-dip recession, the chances of a growth relapse in thesecond half of the year are higher than the equity market, and to a lesser extent the credit market, have priced in. Treasuries seem to be the asset class thatmost closely shares my cautious views. Anyone with a pro-cyclical bent has toanswer for why it is that the yield at mid-point on the coupon curve is below 2%,a year after a whippy rally in equities and commodities and what appeared to bea sizeable policy-induced GDP jump off the bottom.Given the unprecedented massive government intervention across the planet, itcan hardly come as a surprise that economic activity began to recover exactly ayear ago. But when the equity market was hitting its recovery highs in earlyspring, it reflected a widespread view that the green shoots of 2009 would beextended into a sustainable growth phase into the future. Not a goodassumption then; and not one now.All of the optimism that dominated the marketplace over the past yearoverlooked a significant fact. While U.S. banks have recapitalized themselvesand written off debt, this cycle has been dominated by governments socializing  the losses and taking the bad debts from the private sector and transferring theliabilities to the public sector balance sheet. The debt problem was merelyshifted from the private sector to the government sector.The Greek sovereign debt crisis has acted as the proverbial canary in the coalmine, underscoring the view that governments have probed the outer limits of  their deficit financing capabilities. This has important implications for theeconomic outlook since the recovery has really been one part bailout stimulus, to one part fiscal stimulus, to one part monetary stimulus, to one part inventoryrenewal. Now that the boost to growth from the inventory bounce has run itscourse, the stimulative effects of fiscal policy will diminish in coming quarters as the public backlash against further increases in the debt-to-income ratioconstrains the government’s ability to continue to try and fine-tune the economy.The dramatic government incursion into the macro landscape and capitalmarkets obscured the fact that the economy is still in the throes of a multi-yearcredit contraction phase and as such what we can expect is for the pace of activity to weaken substantially during the periods when the stimulus fades.This is what we can expect in the second half of the year and into 2011 when tax rates rise substantially for many Americans.Even if we don’t get a double-dip recession, and I think at a minimum what we’regoing to get is a 2002 style growth relapse when GDP growth converges on finalsales somewhere around a 1% rate; the consensus right now is for a 3% secondhalf growth, which is right where it was heading into the second half of 2002.
Page 2 of 9
Even if we manage to avert adouble-dip recession, thechances of a growth relapse inthe second half of the year arehigher than the equity market,and to a lesser extent thecredit market, have priced inThe dramatic governmentincursion into the macrolandscape and capital marketsobscured the fact that theeconomy is still in the throesof a multi-year creditcontraction phase
July 20, 2010
The difference of course is back then the Fed had had room to cut rates 75basis points, President Bush had the fiscal flexibility to cut taxes dramaticallyand we went and started a war, which is always reflationary. We don’t have these outlets today.
Bad government short-termdecisions over good long-termsolutions are burying the worldinto a graveyard of debt
Moreover, whatever pace of economic activity we see, I am sure that it will beinsufficient to absorb the still-large amount of excess capacity in the system. In turn, what this means is that the U.S. unemployment rate will stay near double-digit terrain for an extended period of time. It also implies that inflation andinterest rates will remain low for a sustained period of time, and, that a stockmarket priced for peak earnings in 2011 could be in for some pretty big disappointment.As for the global economic outlook, the bloom is off the rose as well. The OECDleading indicator in May turned in its softest pace since the depths of despair inMarch 2009. China’s massive stimulus program has run out of steam and thegovernment has been tightening policy this year to redress substantial over-investment in real estate and what may well be an unsustainable price bubble.At the very least, China is unlikely to be the engine of global growth to as greatan extent as it has been. Much of Europe is in massive fiscal retrenchmentmode, and the peaking out in commodity prices will also have dampening effects on the resource-producing countries, particularly in the once-hot LatinAmerican economies.
What keeps you up at night and what worries you most about the investing environment?
Bad government short-term decisions over good long-term solutions are burying  the world into a graveyard of debt. People have to understand that 80% orhigher debt-to-GDP ratios are a new dynamic and a game changer in Europe andin the United States. The bottom line is that all levels of society, and acrossmost countries in the industrialized world, have far too much debt and far toomuch debt-servicing costs in relation to income.For the entire OECD countries, general government debt as a share of GDPalone has ballooned from 73% when the recession started in 2007 and willclimb to a record 104% next year. It took 15 years for this ratio to go from 63% to 73% and just four years from 73% to 103%. Total claims in the OECD at alllevels of society just broke above 360% of GDP and that is clearly unstable.Suffice it to say, many of these debts will not be serviceable — identifying where the defaults and haircuts take place, across countries and sectors, will require a tremendous level of skill.The problem of excessive debt leverage got worse in the aftermath of thefinancial crisis, not better. This is what keeps me up at night — kicking the candown the road in terms of addressing the global debt problem will only end upmaking the situation worse. Governments seem to believe that the solution to adebt deleveraging cycle is to create even more debt. But delaying the inevitableprocess of mean-reverting debt and debt-service ratios back to historical normswill be even more painful.
Page 3 of 9
There is simply no quick fix toresolve the massive globalimbalances that were allowedto build during the prior creditbubble

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