David A.

Rosenberg October 2, 2009

Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave

THUD, DUD AND CRUD
IN THIS ISSUE
There’s no other way to describe the U.S. employment report that was just
released for September. And guess what? The rose-colored glass donning set • We finally could be in the
of economists who have been talking about sequential improvement in the data long-awaited corrective
and how “less negative” the employment numbers have become can’t say that phase in equities
after today (thank the good lord). That’s because at -263,000 on nonfarm • There is a secular theme
payrolls, instead of the -175,000 print that was widely expected, we actually saw afoot which is the boomer
sequential deterioration for the first time since May as the August decline was - drive for income
201,000 (though revised from -216,000; July was revised lower to -304,000 • Is the recession really
from -276,000). If you think that is bad, consider that the Household Survey over?
showed a massive 785,000 plunge in September which again was sequential
• For product-pushing
deterioration because the decline the month before was 392,000. We’ll see if Street economists and
the legions of bulls will add this in their post-payroll write-ups today, but the strategists alike, what
Household survey actually leads the labour market at true turning points in the matters at the margin is
business cycle – and employment on this score has now slid by 1.2 million in the only when the ISM index is
past two months. moving up -- not when it's
moving down
These numbers far from validate the overwhelming consensus view that the • The long-range outlook for
recession has come to an end just because of one positive stimulus-crazed GDP the US dollar is poor but it
print (didn’t we have that in 2008 too?); not to mention the fact that the last does not mean that it will
lose its reserve currency
time we came off such a two-month falloff in Household employment was back
status any time in the next
in March when the stock market was testing fresh 12-year highs. Sustainability decade
is the key and there can be no durable recovery without net job creation and
organic wage growth. Both were lacking in today’s report – in fact, the
combination of the workweek edging back down to retest the all-time low of
33.0 hours and the near-stagnation in hourly wages dragged the proxy for
personal income down 0.2% (reads: in nominal terms) and the year-over-year
trend is getting perilously close to deflation terrain at +0.7% from +0.8% in
August and +1.2% in July.

There were absolutely no redeeming feature in the data, unless you want to
conclude that a modest 2,000 decline in temp agency employment – widely
considered a leading indicator – is good news. The diffusion index sank to 31.9
from 34.9 (and to 22.9 from 28.3 in August) which means that for every
company adding to their staff loads, more than two are cutting back. The labour
force contracted by 571,000 and has plunged now by 1.1 million since May.
That again is a sign of the labour market seizing up – which is very disturbing
when you consider all the government efforts to stem the tide last quarter from
housing subsidies to cash-for-clunkers to mortgage modifications. Full-time
employment collapsed 814,000 – and it is these jobs that ultimately drive
confidence, income and spending. The number of permanent job losses jumped
over 400,000 or by 5% last month as well.

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 2, 2009 – LUNCH WITH DAVE

If the labour force participation rate had not declined to 65.2% from 65.5%, the The fact that initial
unemployment rate would have actually jumped to 10.3%; as if the actual uptick jobless claims have
to 9.832% (to the third decimal place) from 9.657% was good news to begin peaked and rolled over –
with. The fact that initial jobless claims have peaked and rolled over – modestly modestly by historical
by historical standards – tells only half the story which is firings. It is so painfully standards – tells only
obvious from the data, that what is lacking the most is new hiring, especially in half the story which is
the small business sector which accounts for half of the job creation in the firings.
United States. The average duration of unemployment rose to 26.2 month from
24.9 months in August; the median spiked to 17.3 months from 15.4. It is so
difficult now to find a job that a record 36% of the ranks of the unemployed have
been searching with futility now for at least six months.

The U-6 measure of the unemployment rate, which the most inclusive definition
of the labour force and takes into account the fact that we have a record 9
million people working part-time because they have been pushed off full-time
payrolls, hit a new high of 17% in September from 16.8% in August. The gap
between this rate and the ‘official’ rate of 9.8% is at a record of 7 percentage
points. The historical norm is closer to 4 percentage points and so the concept
of mean reversion – Bob Farrell’s first market rule to remember – suggests that
the unemployment rate is going to be setting new highs for the post-WWII era
before too long (the prior high was 10.8% in Nov-Dec 1982), so the chances that
we see a 13% peak unemployment rate this cycle is far from a ludicrous
proposition at this point. And just in time for the mid-term elections.

The index of aggregate hours worked, which combines hours worked with the
number of bodies at work, seemed to be carving out a bottom in July and August
It was in fact a false bottom, because this critical ingredient of GDP fell 0.5% in
September to stand at its lowest level in six years. For Q3, aggregate hours
worked actually contracted at a 3% annual rate so basically, what is keeping the
economy afloat, is continued strong productivity gains. But productivity growth
alone cannot possibly lead the economy into a sustainable recovery – labour
input at some point is going to have to kick in. Let’s just say that as far as the
equity market is concerned, any time it can rally 60% from any low at the same
time that employment craters 2.7 million, tells you that there is a lot of hope
being priced in. Today’s report would suggest that ‘false hope’ is more
appropriate.

MARKET ACTION
We finally could be in the long-awaited corrective phase in equities that will
hopefully give us a chance to ultimately buy the market at more appropriate
valuation measures. We have said 850 on the S&P 500 would be an interesting
price point. Meanwhile, somebody is seeing something, somewhere, and it pays
to note that change occurs at the margin. The CRB index has flatlined since
June and the raw industrials have sliced below the 50-day moving average. The
Baltic Dry index is behaving poorly and likely not all related to fresh shipping
supply. Treasury yields out to the 30-year have broken down and the curve is
flattening which is a possible harbinger of a renewed slowing in growth following
the Q3 stimulus-led spurt. The VIX is also on the rise as the anti-risk trade

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October 2, 2009 – LUNCH WITH DAVE

moves back to center stage. And let’s not forget that China’s stock market,
widely viewed as a bellweather, fell more than 6% in Q3 (even as the S&P and
Dow surge 15%).

Since this was a technically-driven market as opposed to a fundamentally-driven

market, maybe we should be watching the technicals here for the S&P 500:

• 1020 is the 50-day moving average and below that point we break the
uptrend line from the March low.
• 990 to make a lower low during the uptrend since July.
• Ultimate support at the July low is 869. Break that level, and …. (well, let’s
just say it is not good).
Does anybody consider just how critical it is to have had the long bond yield slice
below 4% to 3.95%? The yield curve is flattening big time and since mid- The bond market crowd
September the long bond has rallied more than 30 basis points. That is smells a rat somewhere.
amazing and it means that the bond market crowd smells a rat somewhere – as
it did when it rallied like this as the stock market was making new highs in the
summer of 2007. As an aside, the last time the long bond yield was at 3.95%
was in late April … when the S&P 500 was sitting at 855. We should add that
real interest rates – the bond market’s proxy for real growth -- as measured by
the yield on 10-year TIPS is all the way back to 1.5% after hitting a peak of just
over 2% in early July and again, the last time it was where it is today, the S&P
500 was 20% lower than it is today.

We realize that the positive tone in the Treasury market is a thorn in the side for
the equity market bulls, but think of the bright side; at least the bond rally has
allowed 30-year mortgage rates to drift back below 5% for the first time in a
good four months.

Back to the equity market for one minute. The data points above are meant to
be seen as key technical levels that need to be taken out before we can actually
call this a corrective phase. Keep in mind that we have seen no fewer than
fifteen 2% or worse down-days for the S&P 500 since the lows posted in March
and each time we did not see technical levels pierced to the downside and in
fact, what we never did see was much in the way of any follow-through. So let’s
keep our powder dry before we can start thinking of much more attractive
valuation levels in order to put the dry powder to work! And for those that
believe that the stock market is correct in its assertion that 4% GDP growth is
coming our way in the coming year, not to mention a doubling in corporate
earnings, perhaps a read of Meredith Whitney’s op-ed piece on page A19 of the
WSJ would be worth a read for some sober second-thought (“The Credit Crunch
Continues”). I also highly recommend the article by David Wessel on page A2 of
yesterday’s WSJ (getting a U.S. newspaper in Winnipeg is no easy task) on the
ongoing deleveraging course in the U.S. household sector (“The Downside of
Reducing Debt”). We also wonder aloud how it could be that all the economists,
from academia to government to the financial sector, are all so convinced that
the recession is over at a time when state tax revenues are down a record 17%

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October 2, 2009 – LUNCH WITH DAVE

YoY. This is one consensus call that in the end may be dubbed ‘The Great
Embarrassment’.

MORE ON VALUATION
We feel we’re in pretty good company on this view when we see the FT quote
research showing that the S&P 500 is overvalued by 35% (and here we thought
we were being “skunky” when we said it was overvalued by 20%-25%). This by
the way is based on data using so-called “cyclically adjusted” P/E ratios (the
ratios that Wall Street strategists love to deploy); the market is even more
overpriced using the Tobin Q theory of looking at market value versus
replacement value.

We still marvel at the shills who believe that the market is fairly valued and that
somehow it is not fair to compare how far the market has ballooned over the
March lows since those lows were “artificial”. Excuse me. The 676 closing low
on March 9th was any more of an egregiously oversold low than the October
9th/02 low of 776? Or the August 12th/82 low of 102 when the S&P 500 was
trading at an 8x P/E multiple, a 6 1/2% dividend yield and below book value? It
always appears to be an oversold low at the trough, with the benefit of perfect
hindsight. But the stock market, at the lows, was merely pricing in reality, a -2.5
GDP growth trajectory which is exactly what we will see posted for 2009 when
the books are closed for the year. The market was down 60% from the highs,
but guess what? So were operating earnings. And reported “unscrubbed” To think we can have a
profits tumbled 90%. To think we can have a 60% rally from the lows in six
60% rally from the lows
in six months and
months and believe that somehow this is normal – please. By the time the
believe that somehow
market is up 60% from any low, it usually is up that amount in three years, not
this is normal – please.
six months; and over 2 million jobs have been created. This is the first time the
market has rallied this much with the economy shedding 2.5 million jobs.

Welcome to the latest new paradigm – jobless prosperity. And whether you look
at operating or reported earnings, trailing or forward, the S&P 500 today is
trading at multiples that are higher than they were at the market peak in
October 2007. So we’re not talking about pricing the market with ‘mid-cycle’
multiples – it is trading at ‘late-cycle’ multiples.

WHO HAS BEEN DOING THE BUYING?

We already ascertained earlier in the week that is hasn’t been Ma and Pa Kettle
– in fact, the FT quotes data from TrimTabs showing that only $2.5 billion in net
inflows has gone into U.S. equity funds and ETF’s since the March lows. Inflows
into bond funds have been ten times as strong. We know that corporate
insiders have been net sellers of size. And the buying power from short-covering
subsided months ago.

The answer, and this validated by the FT on page 16 of yesterday’s edition, are
the hedge funds. And once they begin to see signs that a V-shaped recovery is
about as real as Santa or the tooth fairy, watch out. Because there aren’t any
other buyers out there that can be identified.

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October 2, 2009 – LUNCH WITH DAVE

And as we have said before, there is a secular theme afoot which is the boomer
drive for income. Not just the TrimTabs data, and not just the hugely
oversubscribed $8.8 billion sale of California short-term notes (1.25% - 1.5%
yield), but this drive towards ‘safety and income at a reasonable price’ has
driven tax-free bond yields to 40-year lows. So far this year, inflows into these
funds have totalled a record $60 billion. Good story on this on page C8 of
today’s WSJ.

BULLISH SENTIMENT AT AN EXTREME?

From a contrary perspective, it's not complicated. Bullish sentiment is running
at an extremely high level -- too high, in fact, for an economy that is still on life
support.

The latest readings?

Investors Intelligence shows 50.6% bulls, up from 46.7% a week ago. The bear-
share is stuck at 23.5%, hardly budging over the past week. The AAII poll shows
44% bulls (up from 39%) and 35% bears (from 44.6%).
The number of firms
A ‘D’ FOR DIVIDENDS
raising their dividend
Everyone focuses on price, but not enough on total return. And recall that 40% plunged 45% from a year
of the total return in the past was derived from dividend growth. The number of ago in Q3
firms raising their dividend plunged 45% from a year ago in Q3 (191 of the
7,000 universe) in the worst third quarter on this basis on record (according to
S&P). Meanwhile, 113 companies cut dividends, the most in 27 years.

IS THE RECESSION REALLY OVER?

If it is, then the recovery is missing two limbs -- as was the case with the aborted
post-recession turnaround in 2002. While industrial production and real sales
activity appears to have carved out bottoms, it is quite apparent that the other
two ingredients in the recession call -- employment and real "organic" personal
income have not.

Indeed, it pays to note that real personal income excluding government transfers
fell 0.3% in August to a new cycle low. As we saw in 2002, there is no V-shaped
recovery that occurs without incomes rising (and a 26x trailing and 16x forward
P/E ratio is discounting something that's pretty good).

Now, nominal consumer spending did rise 1.3% in August and real (inflation
adjusted) expenditures rose 0.9% -- thanks to the cash-for-clunkers program
which incentivizes consumers to fund their outlays by dragging their savings rate
down to 3% from 4%. This is Uncle Sam at his best trying to play around with
Mother Nature -- because the natural course of events will keep the savings rate
on a discernible uptrend, especially when one deploys a demographic overlay to
the analysis. The government can step in sporadically as it just did, but it can't
reverse the trend -- only briefly disrupt it. When we do the calculation, if
households had not run down their savings flow by 120 billion dollars as they
did in August as they were lured into the auto market, we have news for you --

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October 2, 2009 – LUNCH WITH DAVE

nominal consumer spending would have barely eked out a 0.1% advance and in
real terms we would have seen a 0.2% contraction.

Now put that in your pipe and smoke it!

Finally, it looks like auto sales did beat the most feared estimates out there, but
at 9.2 million (annualized) units in September, that represents a 35% slide from
14.2 million August (and 19% below July’s level). THIS IS TIED FOR THE SECOND
WORST MONTH FOR AUTO SALES IN THE PAST 28 YEARS! At least we know
what the U.S. consumer really looks like when it is off the medication
administered by the administration. Look for Q4 to show flat GDP and
contraction in real final sales. It’s otherwise known as 2002Q4 redux and
remember what the stock market did that quarter (hint: broke to new cycle
lows).

HAS ISM PEAKED?

And if it has, will the bullish Wall (and Bay) Street strategists change their views
(and will their masters let them?). Strategist after strategist came into our
offices ages ago with the doctrine that it didn't matter whether or not ISM was
sub-50, just by rising, it meant that conditions in the industrial sector were
improving even if still contracting. Well, it's amazing how many "don't worry, be
happy" notices we got yesterday, for even if ISM did decline for the first time this
year, from 52.9 to 52.6 in September, it is still signifying expansion in the
manufacturing sector. Ostensibly, for product-pushing Street economists and
strategists alike, what matters at the margin is only when the diffusion index is
moving up -- not when it's moving down. Now, how are we sure that the ISM has
very likely peaked (as auto production crests – it does indeed now look as
though motor vehicle production, which had been the primary factor boosting
output and the manufacturing surveys, has now been totally realigned with
sales)? Well, because the best leading indicator for the index lies in two of the
components -- orders which dropped to 60.8 from 64.9, and inventories which
rose to 42.5 from 34.4. In other words, the orders/inventory ration tumbled to
1.43 from 1.89 in August.

Folks, that is the largest one-month decline in the ISM orders/inventory ratio
since December 1980! The ISM was 53 that month – the next month it went to
49.2 (is that in the market?) and seven months later, we were in the early
stages of the famed double-dip recession (which nobody saw coming at the
time). Food for thought.

As for inflation, prices-paid dipped in September to 63.5 from 66 on the same

day we see a +0.1% print on the August core PCE deflator, which took the YoY
trend down yet again from 1.4% to 1.3% -- the lowest it has been in eight years.

MIXED NEWS ON CONSTRUCTION

Again, the economics community went wild over the news that U.S. Construction
spending rose 0.8% in August. But if truth be told, July was revised sharply lower
(to -1.1% from -0.2%) so the August LEVEL was actually below consensus

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October 2, 2009 – LUNCH WITH DAVE

estimates. Not only that, but the headline number was skewed by a 7.4% jump
in home renovation which doesn't even show up in GDP. What did catch our eye
was the 0.1% dip in non-residential construction (-10.5% YoY) which is an area
of the economy that remains under duress.

U.S. DOLLAR OUTLOOK

The greenback got massively oversold recently and in a period where risk
aversion sets in, it would be reasonable to expect it to rally given its strong
liquidity characteristics. But the long-range outlook for the U.S. dollar is poor
The United States is still
and this does not mean that it will lose its reserve currency status any time in
the world’s dominant
the next decade. As Dennis Gartman pointed out in a brilliant speech he military power; hence it
delivered at a conference that I also spoke at yesterday, a reserve currency can retains the reserve
trade bearishly – the direction is not the definition of a reserve currency; a currency status.
reserve currency is a currency that is easily tradable around the world. The U.S.
dollar has been the world’s reserve currency – the primary means of payment
for global trade and capital flows -- for the past quarter century even though a
quarter century ago dollar-yen was Y270! As Dennis poignantly pointed out, the
country that is the dominant military power in the world is always the country
that enjoys the status of being the world’s reserve currency – and history bears
that out from Spain to the Dutch to the British to America. And there is no doubt
that the United States is still the world’s dominant military power; hence it
retains the reserve currency status and the dollar being in a secular bear market
has little to do with that.

But what about beyond the next ten years? Well, the outlook is rather murky,
and when you see the FT article from yesterday’s edition (page 3 – “Coming Out
as a Military Power With Global Ambitions”) and read how China’s spending on
military has “been growing at double-digit rates for years now”, especially its air
power and navy capabilities, it is quite a shock to say the least. It never ever has
paid in the past century to write off the ingenuity and might of the United States,
but we may look back a decade or two down the road and view what is
happening today as the first signposts that the sun is setting on the hegemony
as has been the case with so many other dominant powers in the past.

To be sure, the fiscal might of the United States has completely eroded as years
of pork-barrel overspending, insufficient resources to deal with a dramatic rise in
dependency ratios in the near future, and decisions to cut taxes while fighting a
prolonged war on terrorisms, have seriously jeopardized America’s financial,
economic and military dominance. The fact that the current Administration is
trying to combat a business cycle with ‘cash for clunkers’ and housing subsidies
(at a time when the tax system already hugely favours homeownership as it is)
shows that fiscal short-termism reigns and that it is completely bereft of ideas of
how to plan for the long-term with regards to enhanced capital formation, skills
and productivity, and sustainable job creation.

Dennis believes that beyond the next decade, the Chinese renmimibi will be the
unit to challenge the U.S. dollar for reserve currency status. And he is the expert
when it comes to the foreign exchange market. As an aside, we both agreed

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October 2, 2009 – LUNCH WITH DAVE

that when it comes to politics, the United States seems to the only major country
shifting its economic policies to the ‘left’. Say what you will about Europe, but
the Merkel victory, coupled with strong leaders like Sarkozy and Berlusconi; the
fact that the Tories will likely soon take over in the UK; not to mention the shifts
in Japan and the success of the Conservatives in Ottawa to sustain repeated
attempts at non-confidence motions, all stand in contrast to the real lack of
“change” in the United States where fiscal policy is dominated by old-school
Keynesian beliefs that you can resurrect a credit cycle via short-term populist
measures. The mainstream economists in the press called ‘cash for clunkers’ a
success, but as we see what sales did in September, all the plan did was distort
the quarterly pattern of spending in the economy and little else, to colossal
taxpayer waste.

And let’s just finish off by saying that if there is a shred of truth in what Karl
Rove had to say in yesterday’s op-ed piece in the WSJ (“Obama Can’t Outsource
Afghanistan”), then gold is likely going to go much, much higher than $1,000 an
ounce. That’s the currency we prefer.

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October 2, 2009 – LUNCH WITH DAVE

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information about the value or risks related to the security or financial
instrument may be difficult to obtain. Investors should note that income
from such securities and other financial instruments, if any, may fluctuate
and that price or value of such securities and instruments may rise or fall
and, in some cases, investors may lose their entire principal investment.
Past performance is not necessarily a guide to future performance. Levels
and basis for taxation may change.
Foreign currency rates of exchange may adversely affect the value, price or
income of any security or financial instrument mentioned in this report.
Investors in such securities and instruments effectively assume currency
risk.
Materials prepared by Gluskin Sheff research personnel are based on public
information. Facts and views presented in this material have not been
reviewed by, and may not reflect information known to, professionals in
other business areas of Gluskin Sheff. To the extent this report discusses
any legal proceeding or issues, it has not been prepared as nor is it
intended to express any legal conclusion, opinion or advice. Investors
should consult their own legal advisers as to issues of law relating to the
subject matter of this report. Gluskin Sheff research personnel’s knowledge
of legal proceedings in which any Gluskin Sheff entity and/or its directors,
officers and employees may be plaintiffs, defendants, co-defendants or co-
plaintiffs with or involving companies mentioned in this report is based on
public information. Facts and views presented in this material that relate to
any such proceedings have not been reviewed by, discussed with, and may
not reflect information known to, professionals in other business areas of
Gluskin Sheff in connection with the legal proceedings or matters relevant
to such proceedings.
Any information relating to the tax status of financial instruments discussed
herein is not intended to provide tax advice or to be used by anyone to
provide tax advice. Investors are urged to seek tax advice based on their
particular circumstances from an independent tax professional.
The information herein (other than disclosure information relating to Gluskin
Sheff and its affiliates) was obtained from various sources and Gluskin
Sheff does not guarantee its accuracy. This report may contain links to
third-party websites. Gluskin Sheff is not responsible for the content of any
third-party website or any linked content contained in a third-party website.
Content contained on such third-party websites is not part of this report and
is not incorporated by reference into this report. The inclusion of a link in
this report does not imply any endorsement by or any affiliation with Gluskin
Sheff.
All opinions, projections and estimates constitute the judgment of the
author as of the date of the report and are subject to change without notice.
Prices also are subject to change without notice. Gluskin Sheff is under no
obligation to update this report and readers should therefore assume that
Gluskin Sheff will not update any fact, circumstance or opinion contained in
this report.
Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheff
accepts any liability whatsoever for any direct, indirect or consequential
damages or losses arising from any use of this report or its contents.
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