David A.

Rosenberg September 27, 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
Another mixed session in Europe but Asian equities are up to start off the week,
and pretty well right across the board, hitting a fresh five-month high (Hong Kong • While you were sleeping:
risk appetite is evident in
has rallied to an eight-month high). The risk appetite is evident in equities but
equities but not so much
not so much in other asset classes with the DXY (U.S. dollar index) rebounding in other asset classes; U.S.
gingerly today (despite the yuan firming) and gold also making up ground on rating agencies are now in
chatter of global central bank buying. Copper, however, is trading a tad lower the process of cutting their
after testing five-month highs. Bonds are also in rally mode and have behaved outlook; in the U.S., it
admirably considering the snapback in the stock market in recent days. continues to be difficult to
get excited about the
economic landscape
The rating agencies are now in the process of cutting their outlook — Moody’s
did so on 120 companies this quarter compared with only 40 upgrades • What happened on Friday?
(according to Bloomberg). Last quarter, S&P cut the outlook for 76 issuers and The “risk-on” is back on
the front burner and the
raised them for 51. Meanwhile, the corporate bond market, in the aggregate,
bulls, right now, have the
has generated a solid 4.6% total return so far this quarter with investment-grade upper hand … but let’s not
spreads in the U.S. tightening further, to 282bps from 317bps at mid-year. get carried away
• Income theme intact: the
It was light on the economic data front today. The U.K. Hometrack Survey
new “D” word is dividends:
showed a 0.4% drop in September U.K. house prices, the third drop in a row. 185 S&P 500 companies
Japan’s trade surplus posted its first YoY decline in 15 months, hence the have raised dividends this
official desire to weaken the yen. Things are so good in Japan that the year while only three have
government is feeling compelled to unveil a new $55 billion fiscal stimulus cut them
package, see page 4 of today’s FT for more. • Why did they do what they
did? The Bank of Canada
As for the U.S.A., everyone will just have to excuse us, but it is very difficult to get embarked on a series of
excited about the economic landscape when: interest rate hikes despite
the fact that the U.S. Fed
• Initial jobless claims are stuck at 465k. has been steadfast on
hold
• There is no absolutely no recovery in bank lending (especially to households —
there was a big $6.3 billion decline in consumer loans and $21.2 billion slide
in real estate credit last week).
• While there was tremendous excitement last Friday over the “core capex”
durable goods orders figure for August, what received short shrift was that
total orders were down 1.3% MoM and have now declined in three of the past
four months. (But hey, why worry about autos just because it is the largest
component?)
• And of course, the four pieces of survey evidence for how the economy is faring
in September as opposed to August have all lined up quite poorly — University
of Michigan consumer sentiment, NAHB housing market index, Philly Fed and
the NY Empire index.

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September 27, 2010 – BREAKFAST WITH DAVE

WHAT HAPPENED ON FRIDAY?

Global equity markets closed at a five-month high, the U.S. dollar was clobbered,
gold broke out to $1,300/oz (silver is outperforming too, at a 30-year high of
$21.38/oz to close out the week), and the Dow rallied 1.9%, to 10,860, making
it four weeks in a row of gains and is up 8.4% for the month. Clearly, in this
relentless game of ‘risk-on, risk-off’, the ‘risk-on’ is back on the front burner and
the bulls have the upper hand.

Two things happened on Friday:

First, a very successful hedge fund manager was on CNBC and (between songs,
apparently) told viewers that the equity market now was a one-way ticket
up. And, second, the durable goods report.

As for this very successful hedge fund manager on CNBC, he laid out two
scenarios as to why he believes the equity market is now a one-way ticket up:

1. If the economy sputtered, the Fed would step in and embark on more
quantitative easing (QE), and that would propel the equity market higher
because it will lead to P/E multiple expansion.
2. If the economy chugs along, then there will be no need for more Fed balance
sheet expansion but the stock market will enjoy the fruits of stronger
earnings growth.
It’s a win-win!

Indeed, based on the all the emails we received on this CNBC performance on
Friday, and given this investor’s recent track record, it would not surprise us at
all if a lot of other hedge funds moved in that same direction. It’s quite
possible. Then again, how likely is it that one man can move the market today?
This is no longer the 1970s when E.F. Hutton was around.

Too bad we weren’t invited as a guest on CNBC last Friday to engage in a

friendly debate with this portfolio manager because he didn’t outline the third
scenario, either because he doesn’t believe it or he just plain didn’t contemplate
it or he’s simply not positioned for it. That third scenario is that the economy
weakens to such an extent that the Fed does indeed re-engage in QE, but that it
does not work. So the “E” goes down and the P/E multiple does not expand.
Maybe it even contracts since it already has spent the past number of years
reverting to the mean as are so many other market and macro variables (for
example, the dividend yield, savings rate, homeownership rate and debt ratios).
In this scenario, the stock market does not go up; it goes down.

Is it possible that QE2 won’t work? The answer is yes. How do we know? Well,
because the first round of QE didn’t work. After all, if it had worked, the Fed
obviously would not be openly contemplating the second round of balance sheet
expansion. If the objective was narrow in terms of bringing mortgage spreads in
from sky-high levels, well, on that basis, it did help.

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But it did not revive the housing market any more than the litany of other
government programs, and the fact that the economy has slowed so sharply to
near stall-speed in recent quarters is all anyone needs to know about the true
success, or lack thereof, from the first round of QE.

The Fed has cut its growth forecast twice in the past three months and has
sliced its inflation forecast three times. This was not was envisaged when the
first round of QE was unveiled last year. Normally, the pace of economic activity
is accelerating to over a 5% annual rate in the second year of recovery, not
slowing down to below 2% — especially with all the monetary, fiscal and bailout
stimulus that is in the system.

Here’s the bottom line: if not for the stimulus and the inventory swing, the
economy would have actually contracted this year.

There is not enough evidence to conclude that QE will be successful in terms of

giving the economy a sustained boost in a cycle of contracting credit and the
lingering trauma on the baby boomer balance sheet with net worth down over
$100,000 for the average household from the level prevailing three years ago.
Japan’s experience with QE, and the limited success it has had, may also be
used as a case in point.

Now as far as the market reaction is concerned, it was completely in line with
historical knee jerk “don’t fight the Fed” responses. The Fed cut the discount
rate 50bps on August 17, 2007 — the cut was intra-meeting before the market
opened. Bernanke was getting ahead of the curve and was going to save the
day. I got call after call that day to not fight the Fed and indeed the S&P 500
surged 2.5% and went on to gain another 10% by the October 9th high; then
reality set in.

In all honesty, when the Fed cut the discount rate repeatedly in the summer of
‘07, the widespread consensus was that the Fed was on the case and that a
soft-landing lay ahead. Just like today, when so many investors are can be
mesmerized by what was really an incomplete set of analysis espoused on CNBC
last Friday.

Back in 2007, nobody believed that a recession could ensue absent a

substantial inversion of the yield curve. Well, as it turned out, it turned out to be
a case of welcome to the vagaries of a post-bubble credit collapse. Today, we
hear about a ‘soft landing’ yet again and that it is impossible to have a double-
dip recession since they have never happened in the past. That is a dangerous
assumption to make — just like it was a dangerous assumption to say that home
prices cannot go down because they never have in the past.

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To reiterate, I’ve been around the track many times. I heard all the arguments
then about what a lower discount rate does to equity valuation. It’s okay. The
market rallied 10% and sucked in a lot of folks. The economy was far stronger
then too. What everyone missed was the “E” and the failure of the Fed to
control it in a credit contraction. Back then the jobless rate was 5%. Today it’s
close to 10%. Play this very gingerly. The profit share of GDP is back to a cycle
high, so this is no longer a case where modest low-single-digit economic growth
delivers a double-digit earnings stream. In our view, assuming moderate
buybacks, revenues that grow in line with an anemic nominal GDP trend, and
margin compression, it would still leave us with, at best, a flat corporate earning
profile for the coming year.

Then the Fed first announced it was going to embark on QE1 on December 16,
2008:

“The focus of the Committee's policy going forward will be to

support the functioning of financial markets and stimulate the
economy through open market operations and other measures
that sustain the size of the Federal Reserve's balance sheet at a
high level. As previously announced, over the next few quarters
the Federal Reserve will purchase large quantities of agency debt
and mortgage-backed securities to provide support to the
mortgage and housing markets, and it stands ready to expand its
purchases of agency debt and mortgage-backed securities as
conditions warrant.”

The S&P 500 soared 5% that day and tacked on another 2% over the next three
weeks. A great trading rally to be sure, but it was short-lived. It did not stop the
market from plunging nor did it stop the economy from contracting in each of
the next two quarters. Don’t fight the Fed! We know what happened next.

Folks, we are in a period of extreme economic uncertainty. The Fed is being

forced to be doing something that they don’t even know is going to work. It does
not leave us with a very warm and fuzzy feeling.

The market rallied sizably right after the first discount rate cut and after the first
QE announcement. These rallies were short-lived, as we illustrated above. To
be sure, the rebound in the stock market last year was impressive, but it was not
really related to QE. It was when the market began to price out the recession
and price in a recovery and the reality is that profit growth did swing to positive
terrain in significant fashion, equity analysts were raising their estimates and
company executives were raising guidance.

However, the exact opposite is happening now. On a seasonally adjusted basis,

corporate earnings slowed markedly to low single-digits in Q2 from Q1 — the
extent of the slowing is being masked by continued double-digit gains in the
year-on-year numbers — even though on that score, the comparisons are soon to
become much more challenging.

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Analysts are cutting their estimates right now (though not so much for 2011 ...
yet) — reducing their profit forecasts on 521 companies in the past four weeks
while increasing them on just 391 stocks (see “The Trader” on page M3 of
Barron’s). According to our friends at CIBC World Markets, over 60% of 2010
earnings revisions have been to the downside in recent weeks, the highest ratio
so far this year, and more companies are reducing rather than lifting guidance
as well.

Not only that, but the factors that propelled the economy last year, which was
the tremendous government stimulus and the huge inventory swing, are set to
the run their course, with little left to help act as an offset. There is at least 1.5
percentage points of fiscal drag coming next year at a time when inventories will
likely no longer by contributing to headline GDP growth and we already know
that the baseline trend in real final sales is running at less than a 1% annual
rate. This is all a prescription for an economic contraction, not expansion, and
as such, we actually view our forecast as being somewhat hopeful and perhaps
not bearish enough. But we like to keep an open mind.

All we know is that we would be much more convinced over the case of a
sustained bull market in equities if consensus views were closer to $70 or $80
on EPS for next year, as it pertains to the S&P 500, than the current $95
forecast, which implicitly assumes either a vigorous uptrend in nominal GDP or
profit margins expanding to new record highs. A $95 operating EPS for 2011 is
a 14% jump, which is easier to do in an anemic nominal economic growth when
margins are at a cycle trough; a runup like this would be extremely rare
considering the V-shaped bounce in margins back to cycle highs. We would not
advise putting on big bets on either of these developments taking hold.

Maybe, just maybe, we will look back and say, geez, the bond market did have it
right, after all — as it did in 1990, 2000 and 2007. And geez, there was
probably a reason why consumer confidence was back to where it was in March
2009. And maybe there was a reason why the National Bureau of Economic
Research declared the end of the recession but laden with caveats and nothing
to say about the contours of this statistical recovery. Maybe we will look back at
the current levels of the NAHB housing market index, the consumer sentiment
index and the NFIB index and wonder how it is that anyone could have believed
a sustained recovery had begun with these metrics at levels consistent with
recessions, not expansions.

“As noisy as the near-term may be, a run towards the April highs appears more
likely.” These are the words from Michael Santoli at Barron’s (great article too —
Jumping to Conclusions on page 17). It may well be the case because after all,
the stock market surged both in the fall of 2000 and again the fall of 2007 to
new record highs, and both times even as recessions lurked around the corner.

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If you have conviction over the veracity of this rally, as impressive as it has been
this past month, then absolutely go ahead and put your money to work. That is
your right, but only if you have the conviction. We read the total lack of volume
as a sign of very little conviction in the institutional investment community and
we share that sentiment. It’s not that the market can’t rally, we just don’t have a
strong enough conviction over its sustainability. Friday was a case in point
where we had a flashy 2.1% rally on 4.3 billion shares traded on the big board
versus the five billion daily average so far this year. We endured the worst
August for the S&P 500 since 2001 and followed that up with the best month
since March 2000 (best September for the Dow since 1939!) — right when the
tech mania was about to peak out and roll over.

At the same time, it also pays to assess what the “price” is signalling and
everyone has or should have a point of capitulation. If — a big if — the S&P 500
manages to pierce the April highs and does so with: (i) on high volume, (ii) led by
the financials, and (iii) confirmed by the transports, then indeed, that will be a
very constructive signpost not to me ignored.

However, what if what we are seeing right now is the continued intense volatility
as the secular forces of deflation bump against these periodic policy reflation
efforts. One day it is another fiscal announcement as the White House did a few
weeks ago (shhh... but it’s not a “stimulus”), another day it is a Fed
announcement (QE2), and another day it’s another bailout (oh yes, see the
latest on the front page of the weekend WSJ — Credit Unions Bailed Out). Maybe
instead of going and retesting the April highs, which now almost seems like a
given to the pundits we read over the weekend, maybe what we have on our
hands is a move to the right shoulder in what looks to be a classic heads-and-
shoulders pattern emerging. Hey, in a market governed largely by technicals
and sentiment, these things matter. And, as for sentiment, most of these
indicators have very quickly moved to “contrary negative” bullish readings. Not
only that, but the market has become seriously overbought with almost three in
four stocks now trading above their 50-day moving averages compared with one
in four earlier this month (see “The Trader” on page M3 of Barron’s).

What was the second thing that happened on Friday?

The durable goods report, which created a tremendous amount of excitement:

“It’s the realization that the double-dip is receding in probability and I would say
the durable goods data today is in some sense the icing on the cake.” On page
14 of the weekend FT.

“The durable goods orders are consistent with the recent string of economic
data suggesting that the U.S. economy might be stabilizing.” On page B7 of the
Saturday NYT.

“The concept of a double-dip recession has been replaced with slow and steady
improvement, and even if we don’t get it, we have a Federal Reserve that's
ready to step in and support the rally.” On page B1 of the weekend WSJ.

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“The biggest news today was the durable goods orders. This should serve as a
stake in the heart of the perma-bear double-dippers.” On the front page of the
Investor’s Business Daily — wow, talk about fighting words.

This conjures up Bob Farrell’s Rule 9 — “When all the experts and forecasts
agree - something else is going to happen.”

So, what was this all about? The fact that non-defense capital goods orders
excluding aircraft (also known as core orders) came in well above expected at
4.1% MoM in August. As solid as that was, It is absolutely remarkable that such
faith is put into such a volatile indicator. But these remarks above do indeed
deserve a thoughtful response:

• First, this is a notoriously volatile series: -2.8% MoM in April, +4.7% in May,
+3.6% in June, -5.3% in July, and +4.1% in August. It’s a yoyo. Back to the
start of 2009, the range on this metric has been -9.9% to +6.7%.
• Second, it pays to smooth out the data, say on a three-month annualize rate
basis. This trend has gone from 39.3% in May, to 23.9% in June, to 11.5% in
July, to 8.8% in August. So, the trend is positive but it is slowing as far as
these data pertain to core capex spending intentions.
• Third, the data were for August and we already know that the NY Empire and
Philly Fed indices in September revealed a softening in industrial activity.
• Fourth, the Fed downgraded, at the margin, its outlook for capital spending in
last week’s press statement.
• Fifth, the reason why core orders are so coveted is because they are a proxy
for business capital spending. But they don’t capture everything going on in
the economy, like auto production or exports. It was somehow lost in all the
commotion on Friday that total durable goods orders fell 1.3% MoM in August
and are down now in three of the past four months — not to mention no higher
today than they were a decade ago!
CHART 1: THE LEVEL OF DURABLE GOODS ORDERS ARE NO HIGHER
TODAY THAN THEY WERE A DECADE AGO
United States: Manufacturers’ Durable Goods New Orders
(US$ billions)
260

240

220

200

180

160
99 00 01 02 03 04 05 06 07 08 09 10

Source: Haver Analytics, Gluskin Sheff

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• Sixth, the automotive sector is the largest component of orders and it is not
included in the “core capex” series, but orders collapsed 4.4% MoM and
shipments by 5.0% in August. Make no mistake, there was such a huge “build
in” already that auto production has given a huge lift to GDP growth in Q3. But
looking at the trend right now, the key auto sector is going to emerge as a huge
drag on the economy in the fourth quarter. The U.S. is also a huge exporter of
aircraft and so we would expect to see the 2.7% slide in bookings here (second
decline in a row) to show through in a deterioration in the foreign trade data.
I have to say that I really love that statement from one of the pundits above — “and
even if we don’t get it, we have a Federal Reserve that's ready to step in and
support the rally.” The Fed cut the funds rate to zero in December 2008. Did that
work? Obviously not or there would have been no need for QE1. Did QE1
work? Well, by definition, no, or else we would not be discussing QE2. Now if the
metric of success is that things would have been far worse without all this
stimulus, well, then maybe we can acquiesce on that one. But if we use that logic
as a yardstick, then let’s also fess up and admit that this is becoming a bit more
like Japan than anyone would have imagined even a year ago.

I mean, the fact that we are even engaged in a debate over a double-dip recession
is remarkable because given the massive amount of government assistance we
should really be debating what sort of V-shaped recovery we should be seeing right
now. Whether we get the double-dip — and just because it has been delayed does
not mean it has been derailed — is really immaterial. The fact that it is even topical
speaks volumes and attests to the view that nothing has really worked if the
benchmark is a sustainable economic expansion as opposed to how bad things
would have been absent all the interventions and incursions. Hopefully that
makes some sense. We think it does.

The next question is what about the housing data? Well, a market commentator,
who was quoted on the front page of the IBD, said that “the numbers are
immaterial.”

Oh, how convenient. Let’s ignore the bad data and embrace the good data —
even when that good data has some blemishes on it, as was the case with the
durables report.

New home sales were flat in August, at 288k at an annual unit rate, below
consensus views of 295k and tied for the second lowest level on record (going
back five decades). On a non-seasonally adjusted basis, the number of sales of
newly completed homes was abysmal, at 10k, down 38% from the anemic levels
of a year ago, while the backlog of newly built homes sitting empty and for sale
sitting at 81k and down a comparatively smaller 30% over the past year. The
builders have not done enough to curb the excess inventory — this is still very
much a buyer’s market with the unsold inventory at 8.6 months’ supply — even if
off the January 2009 peak of 12.1 months.

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This, in turn, is showing through in the median new home price — falling 0.6%
MoM in August after two months of declines exceeding 5% and now down in four
of the past five months. Median new home values, at $204,700, are down to
levels not seen since December 2003. Is lingering deflation in residential real
estate something to cheer about?

CHART 2: NEW HOME PRICES ARE BACK TO 2003 LEVELS

United States: New Single-Family Median Home Price
(US$)

275000

250000

225000

200000

175000

150000
99 00 01 02 03 04 05 06 07 08 09 10

Source: Haver Analytics, Gluskin Sheff

What was ignored on Friday

It was not just the housing data. For the first time, a House Committee passed a
bill aimed at retaliation against China’s currency policy — allowing the Commerce
Department to slap tariffs on goods sold by “currency manipulators.” The full
House is expected to approve the bill this week — and with bipartisan support to
boot.

Meanwhile, China just slapped on a steep tariff on U.S. poultry (see page B1 of
today’s NYT). And another form of protectionism is setting in as well from the
U.S. side — see The Send Jobs Overseas Act on page A18 of today’s WSJ and Bill
on Overseas Jobs Raises Hopes and Fears in U.S. on page 3 of the FT.

China is also making the news on other fronts and the latest “incident” was the
confrontation with Japan in the East China Sea (see the editorial section on page
A18 of the Saturday NYT). Perhaps this is another reason to load up on gold and
commodities but hardly something that should be underpinning a P/E expansion
in the equity market.

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INCOME THEME INTACT

The new “D” word is dividends: 185 S&P 500 companies have raised them so
far this year while only three have cut them — compare that to this time last year
when those numbers were 110 and 72 respectively (see page B14 of the WSJ).
And, as the weekend FT notes (page 15), much of the rally off the July lows has
been in dividend-yielding sectors such as telecom services (up 20% from the
late-May low), utilities (up 13% since the end of June) and consumer staples.

All that said, there are just too many unusual things going on right now:

• We are in the midst of a huge equity market rally not being fuelled by the
financials, which have lagged by a full percentage point this month and are still
down 14.4% from this year’s highs.
• Equities and gold are typically inversely correlated since the latter is a hedge
against fear and uncertainty, and here we have gold breaking out to new highs.
• A 0.4% yield on the 2-year note and 2.6% on the 10-year Treasury do not seem
like levels that are consistent with the sort of growth that is being priced in by
the stock market. (Yes, yields ticked up on Friday as bonds cheapened ahead
of next week’s $100 billon note auctions.)
• The euro is rallying against the U.S. dollar to five-month highs despite the fact
that fiscal concerns are boiling over again among the Club Med countries —
Irish CDS spreads hit record levels last week and yield spreads over Germany
also surged to record wide levels, ditto for Portugal, despite apparently
successful bond auctions.
• Despite below expected readings on the NAHB index and new home sales, the
S&P Home Building index finished the week with a 3.1% surge.
WHY DID THEY DO WHAT THEY DID?
I get this question all the time, and it surrounds the Bank of Canada’s decision
to embark on a series of interest rate hikes (three to be exact) despite the fact
that the U.S. Federal Reserve has been steadfast on hold and has continuously
pledged to keep policy rates at zero for “an extended period”. And now, we have
a Canadian dollar that is at least a nickel above any realistic estimate of fair-
value, which is acting as a severe tourniquet on our export sector and a pace of
overall economic activity that is throttling back in a material way.

Our tracking of real GDP for this quarter is about 1.0-1.5% annual rate — not
only below what was a disappointing 2% growth rate in Q2, but a huge
deceleration from the peak pace of 5.8% in the first quarter of this year when we
were giddy with gold medal thoughts from the men’s hockey final and at the
same time patting ourselves on the back for our apparent ability to “decouple”
from the listless U.S. economy.

Well, our economy is now slowing down at a more pronounced rate than is the
case south of the border and the Bank of Canada’s latest 2.8% forecast for third
quarter real GDP growth is looking stale, to put it charitably.

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Not only is the real economy slowing down more than expected, but inflation is
also coming in extremely tame, at 1.8% this quarter, also below the Bank’s
latest 2.1% projection. Remove the effects of indirect taxes, such as the recent
imposition of the HST in Ontario and B.C., and the inflation rate is coming in at
1.1% versus expectations of 1.7%. One would not ordinarily link an underlying
inflation rate of around 1% with an aggressive central bank tightening posture.

At its last policy meeting, the Bank stated in its press statement that “any
further reduction in monetary policy stimulus would need to be carefully
considered in light of the unusual uncertainty surrounding the outlook.”

While global financial strains seem to have eased for now, there is no doubting
the fragility of the recovery and the sharp slowing across most of the economic
indicators, which would suggest that a pause in this Bank of Canada tightening
cycle is in order.

But the question lingers: why did the Bank bother to raise rates at all? Didn’t it
learn the lesson from that ill-timed and ill-fated tightening in 2003 — a rate-
hiking cycle ahead of the Fed that was not only quickly aborted but completely
reversed?

Well, even though I was one of the “doves” advising the Bank to refrain from
raising rates earlier than planned, there was indeed method in its madness.

When the Bank followed the Fed on the path towards microscopic policy rates in
the opening months of 2009, and we have to remember how close we were to a
global financial nightmare, it pledged to maintain such an unprecedented
degree of stimulus “conditional” on a prolonged period of economic malaise.
(To its credit, the Bank never did embark on the path towards quantitative
easing, which makes it stand out as one of the few monetary authorities that did
not resort to jeopardizing the sanctity of its balance sheet.)

The problem, especially for interest rate “doves” like me, is that instead of
seeing a listless economic recovery in Canada, we saw a bounceback of massive
proportions. So much so that in short order, Canadian employment rose to new
all-time highs — all the severe job losses in 2008 and early 2009 have been
recouped — while the U.S. is still more than seven million jobs shy of its pre-
recession peak. If you put our unemployment rate on the same apples-to-apples
labour force definition, it is actually 7.1% today, again in stark contrast to 9.6%
south of the border. So it looks as though the Bank of Canada has certainly
been vindicated.

But there is more to the story. I recall all too well a meeting I had with Mark
Carney back in November 2007 at his office in Ottawa, soon after his
appointment as Governor. At the time, I was in my prior role as chief economist
for Merrill Lynch, and he asked me what I was hearing regarding any problems
on Freddie Mac’s balance sheet. The whole session was about solvency issues
regarding Freddie.

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About three months later, I was invited to participate at an advisory board

meeting at a legendary hedge fund and the talk centered on Freddie Mac. It
was insolvent. And despite former Treasury Secretary Paulson’s infamous
“bazooka”, Freddie, along with Fannie, became wards of the state that summer.

I have known Mark Carney for several years and he never bought into the
widespread view that the crisis in the U.S. housing and credit markets would
miraculously be “contained”. I had no hands-on knowledge but I assume that he
saw the roots of the housing bubble at least being partly attributable to the
Greenspan-Bernanke decision to keep interest rates close to the floor in 2003
and well into 2004 despite a housing and credit boom that was morphing into a
mania. Perhaps they wanted this backdrop as an antidote to the lingering
deflation in the technology capital stock, maybe they didn’t believe the post-
dotcom bust and post-9/11 recovery would be sustained, or maybe a bit of both.

However, the reality was that the Fed kept the funds rate at 1% a year after
taking it there in June 2003 in the face of a 4.5% pop in nominal GDP growth
and a speculative surge in housing activity and credit usage that ultimately sank
under the weight of their own dramatic excesses, taking the entire economy and
capital markets along for the gut-wrenching ride.

The situation was not nearly as dire in Canada and the banks here were well
capitalized and of course have recourse in cases of default. But at the same
time, the dramatic recovery that Canada has enjoyed in the past year, like the
U.S. in 2003 and 2004, has been due to a surge in credit growth and housing-
related spending that must have the central bank feeling a bit uneasy.

Bank-wide mortgage lending has risen 10% in the past year — compared with 4%
in wage and salary income. How sustainable was that?

The ratio of total household debt to income rose to near all-time highs of 146%
— right where the U.S. peaked at the height of its credit bubble. Anecdotal
evidence suggests that the homeownership rate rose to record levels of 70%,
also nearly where the U.S. peak out during the housing bubble.

At the peak of our own mania last fall, home prices soared more than 20% on a
year-on-year basis from their 2009 highs and home sales skyrocketed 70%.
These data points all have a certain “U.S.A. circa 2005” feel to them. The
problem was that by 2005, earlier perhaps, the seeds were sown for what
turned out to be the most dramatic housing bubble in modern history.

The Bank of Canada was not alone in spurring this huge — and unanticipated —
housing boom. The previous dramatic easing of CMHC underwriting criteria
made housing tremendously more affordable for the marginal borrower —
financing with almost no money down at near-zero short-term interest rates.

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September 27, 2010 – BREAKFAST WITH DAVE

While there are no official data on this, one would have to assume that the
volume of mortgages issued in the last 12-18 months with ultra low loan-to-
value ratios and short-term interest rates will be defaulting before long,
especially now that housing supply has surpassed the underlying demand and
thus sent nationwide home prices into reverse (equity in the home is the most
important determinant of delinquencies and defaults, with unemployment a
distant second).

We will probably find out some time in the next year who is standing naked on
shore as the tide rolls in — as all the speculative high-ratio loans come due at
interest rates that are above where they were at the time of origination, courtesy
of the Bank of Canada’s tightening cycle, which may or may not have fully run its
course.

A stitch in time saves nine. As market participants debate the timing of the next
move, I am sure there is debate at the Bank as to whether it would have been
prudent to have dropped the “conditional” pledge to keep policy rates near the
floor even earlier than it did.

This is not at all an attempt to play Monday morning quarterback or to second-

guess the Bank of Canada. But I’m sure that there is a lot of hand-wringing
going on because bursting a bubble, or defusing a mania, is no easy task. No
doubt there is ample room for debate as to whether the Canadian residential
real estate market was a bubble at the recent peak, and, after all, there is plenty
of evidence to suggest that solid foreign demand will provide a firm
underpinning, even in a downturn. (Meanwhile, Canadian investors are flocking
to beaten-down properties in Florida, Nevada and California).

Bubble or not, our analysis found that every basis point of the Canadian
economic recovery was due both directly and indirectly to the boom in the
housing sector. That goose is no longer laying any golden eggs.

In fact, from the nearby peaks, single-family housing starts have plunged 32%,
residential building permits have sagged 17% and home prices, on average, are
down 6% from their once-lofty levels. In the absence of an export resurgence,
which seems unlikely given the ongoing sluggishness in the U.S. economy, the
turndown in housing and the commensurate “spill-over” effects are bound to
keep the pace of domestic activity rather sluggish in coming quarters.

In some sense, that is probably the best case scenario. Housing cycles, both up
and down, tend to go further than anyone thinks, as we saw occur in the United
States, which is still suffering from a post-bubble hangover three years after the
initial turndown. Even if this correction in housing is a fraction as harsh as was
the case south of the border, the economy, and the financial markets, are likely
in for a rude awakening in coming quarters as lower home prices cut into
household wealth, confidence and spending plans.

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September 27, 2010 – BREAKFAST WITH DAVE

At the same time, housing deflation and a rising tide of mortgage delinquencies
will bite into CMHC reserves and, at the margin, undercut the quality of
seemingly pristine Canadian banking sector balance sheets — where $500
billion of residential real estate loans reside (representing 30% of total bank
assets).

The OECD released a damning report on the state of Canadian consumer

finances and concluded that they are extremely vulnerable to any adverse
shocks — including the lagged effects of even a moderate rate-hiking cycle on
mortgage refinancing costs.

It may well be that Canada escaped a housing bubble and its inevitable
aftershocks. But it is a close call and at least you know what keeps me up at
night. Even if it wasn’t a bubble, it looked like a giant-sized sud — excessive
leverage, overvaluation and widespread participation are the three classic
hallmarks. Here’s hoping the Bank of Canada navigates this process better than
the Fed did, assuming it's already not too late.

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September 27, 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
assets of $5.5 billion.
Gluskin Sheff became a publicly traded
corporation on the Toronto Stock
Exchange (symbol: GS) in May 2006 and
remains 54% owned by its senior
management and employees. We have
public company accountability and
governance with a private company
commitment to innovation and service.
Our investment interests are directly
aligned with those of our clients, as
Gluskin Sheff’s management and
employees are collectively the largest
client of the Firm’s investment portfolios. shareholder-minded management and a
We offer a diverse platform of investment
strategies (Canadian and U.S. equities,
Alternative and Fixed Income) and
investment styles (Value, Growth and
1 2010 versus $5.4 million
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 $10.9 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
our clients, as Gluskin
levels. Our performance results are those
Sheff’s management and
of the team in place.
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.
$10.9 million2 on June 30,
For corporate bonds, we look for issuers
with a margin of safety for the payment
for the S&P/TSX Total
of interest and principal, and yields which
Return Index over the
are attractive relative to the assessed
same period.
credit risks involved.
We assemble concentrated portfolios —
our top ten holdings typically represent
between 25% to 45% of a portfolio. In this
way, clients benefit from the ideas in
Our success has often been linked to our

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
2
between our bottom-up security-specific questions@gluskinsheff.com
usd for the S&P 500 Total Return Index fundamental analysis and our top-down
over the same period.
macroeconomic view.

Notes:
Unless otherwise noted, all values are in Canadian dollars.
1. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.
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 15 of 16
September 27, 2010 – BREAKFAST WITH DAVE
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