David A. Rosenberg Chief Economist & Strategist drosenberg@gluskinsheff.

com + 1 416 681 8919

January 5, 2010 Economic Commentary

ARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave
WHILE YOU WERE SLEEPING Market action overseas:
• Mixed overall in the equity market with Asia up an impressive 1.2%, to a 16-

IN THIS ISSUE • While you were sleeping — mixed action in overseas equity markets; bonds are trading defensively; commodities rallying; economic data were circumspect • Interesting revelations yesterday — the Dow ended the year down 120 points, and starts the year down 150 points. What changed in 24 hours? • What can equities possibly be discounting? • The new frugality theme continues on • ISM index up in December … but only half of the 18 industries reported growth on the month • Auto sales are now coming in around 11 million units (annualized) — this is the new normal • U.S. small businesses still in a credit quagmire • No housing recovery in the U.S.

month high. However, Europe is losing some earlier momentum.

• Bonds are trading slightly defensively just about everywhere. • Oil continues to rally (now up nine days in a row) on the cold weather snap,

but gold is hanging in nicely and copper has broken out (though off a tad this morning). kiwi testing one-month highs. The Yen is firm, the Pound weak and the Euro consolidating.

• Commodity currencies are firm with the Aussie dollar and the New Zealand

The data overnight were circumspect:
• French consumer sentiment fell in December for the first time in four months. • While much is being made by the 3,000 drop in German unemployment in

December (the fifth straight decline), like many of the U.S. data releases for the month, there were some friendly ‘seasonal adjustment factors’ at play — the raw data actually showed a 32,000 increase in joblessness and the unemployment rate ticking up to 7.8% from 7.6%.

Good corporate news If there is good corporate news out there, it is in the behaviour of bonds as credit spreads have collapsed in the past month (to nearly 250bps for 10-year Baa product from around 300bps). The S&P speculative default rate fell last month for the first time since the crisis intensified in October 2007. And, we see that the distress ratio — the share of high-yield corporate debt trading in excess of 1,000bps over Treasuries — has collapsed to 15% from 70% just a short nine months ago. We have been constructive on spread product but one would have to believe that the easy money has been made and that a disciplined focus on quality, duration and liquidity (cash on hand) as well as sector specifics (less cyclical the better) is recommended at this time. INTERESTING REVELATIONS YESTERDAY The Dow Jones Industrials was down 120 points on the last day of the year; up 155 points on the first day of the year. Who knows what changed in 24 hours. Remember that out of the blue, the Dow surged 1,500 or 20% from November 20, 2008 through to January 2, 2009; only to then collapse nearly 30% in the next two months. Yes, yes, the ISM manufacturing index did hit a four-year high, but as the guy who conducts the survey (Norbert Ore) warned, aggressive seasonal factors were behind the improvement. He estimated that the factors added seven percentage points alone to both the orders and production subindices!

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

January 5, 2010 – BREAKFAST WITH DAVE

Paul Krugman joined Martin Feldstein on the rain-on-the-parade squad by laying down 30-40% odds of another recession unfolding in the second half of the year as inventory restocking and fiscal/monetary stimulus both begin to fade. We see that Steve Roach, in a piece he published for Bloomberg News, is also calling for 30% odds of a double dip in the global economy this year. Despite the strong move in the stock market, bonds traded on an even keel. Maybe 4% isn’t such a puny yield in an economy that is still gripped with serious pockets of deflation. Yesterday we saw Colorado cut its minimum wage to $7.25/hour from $7.28 because the state’s price level deflated 0.6% last year. This was the first decline in the minimum wage in any jurisdiction since … 1938 — a year that is still very much front and center on Ben Bernanke’s mind. No doubt that the global economy appears to be on a firm footing, but much of this has reflected dramatic fiscal stimulus, overbuilding and credit extension in China. Only the future knows how sustainable this is. We do know that just about all the growth in the U.S.A. in Q4 is coming from inventory restocking; and that every basis point of growth in Q3 came from government stimulus, directly and indirectly. The same stock market that couldn’t see a recession coming in late 2007 even though it was two months away, doesn’t see how low-quality this “recovery” is since there is nothing organic about it. The market is relying continuously on government support, so much so that nearly 20% — by far a record — of U.S. personal income is now coming from Uncle Sam’s generosity in the form of transfers. This deserves a lower-than-normal price-earnings multiple, but it may take time for Mr. Market to figure this out, just as it took several quarters for it to see the effects of a housing recession and credit collapse two years ago. The stock market, in other words, has managed to become a classic lagging indicator. CHART 1: HANDOUTS NOW ACCOUNT FOR ALMOST ONE-FIFTH OF PERSONAL INCOME
United States: Personal Current Transfer Receipts as a share of Personal Income (percent)
20

Krugman, Feldstein and Roach see 30-40% odds of another recession unfolding

Nearly 20% of U.S. personal income is now coming from Uncle Sam’s generosity

18

16

14

12

10 80 85 90 95 00 05

Shaded region represent periods of U.S. recession. Source: Haver Analytics, Gluskin Sheff

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January 5, 2010 – BREAKFAST WITH DAVE

Of course, we hear how great the economies are overseas, but the only areas with any real dynamism are the BRIC countries. But here is the problem; exports to these counties ($130 billion) account for less than 1% of U.S. GDP. So where exactly is the arithmetic here that will support the economy if and when the Fed, White House and Treasury ever loosen their grips? WHAT CAN EQUITIES POSSIBLY BE DISCOUNTING? Sentiment is wildly bullish, underscored by the lowest portfolio manager cash ratios since the market peak of October 2007, the VIX index at 20 (this is problematic), and almost every survey are overwhelmingly constructive. The Barron’s 2010 outlook had “groupthink” written all over it. All 12 strategists/PMs polled are calling for an up-year — by 11% on average, to 1,240 on the S&P 500. Consensus is $76 on EPS earnings and +3.2% on real GDP. Nine of the 12 see higher bond yields, to 4.25% for the 10-year Treasury note. In terms of sectors, tech was the most heavily favoured by far (nine of 12 had the group overweight). For the health care sector, there were more underweights (5) than overweights (4), and utilities were far and away the most out-of-favour sector (underweight by eight of the 12 strategists — compared to four for financials!). We ran some simulations back to 1955 and found that historically, what is normal is that every basis point of nominal GDP growth typically generates 2.5 percentage points of corporate earnings growth. The consensus sees $76 of operating EPS for the S&P 500 next year, which compares to a likely $56 stream in 2009. In other words, that would imply an expected 36% profits boost this year. That in turn would require a 14% increase in nominal GDP, which is basically impossible. Okay — a spurt that strong was last posted in 1951, so let’s be fair. It’s a 1-in-58 event. In the past 75 years, there were a grand total of six when profit growth topped 30%, and guess what? That pace of profits required, on average, 10% growth in nominal GDP. And that last happened 25 years ago. Either way you slice it or dice it, achieving the consensus profit forecast is an extremely low-odds scenario. Meanwhile, the consensus basically sees 4% nominal GDP growth for 2010, which would suggest a 10% profit rise in 2010, which would imply a solid but somewhat less exuberant $62 EPS call for the year. Remember that this time last year the consensus was at $77 operating EPS for 2009 and we got $56 — what saved the market was the Geithner & Bernanke show. What do they do for an encore this year? Keep that last point in the back of your mind. At the end of 2008, the consensus was at $77 for S&P 500 operating EPS for 2009. Even by the end of January, when it was so obvious that the bear market and recession were far from over, the bottom-up consensus was calling for operating earnings to come in at just under $70 per share. What did we end up with for 2009 when all was said and done? Try $56 EPS or 27% below what “market participants” were predicting when the year began.

Barron’s 2010 outlook had “groupthink” written all over it

The consensus sees $76 operating EPS for the S&P 500 in 2010, which would be a 36% increase from 2009

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January 5, 2010 – BREAKFAST WITH DAVE

Forget all the calculations off the “artificial” March lows. Forget the 25% slide in the first 10 weeks of the year to that awful trough. Here is the reality. The S&P 500, from point to point, rallied 23% in 2009 even though earnings for the year as whole came in a whopping $22 a share or 27% below what was being priced in at the start of the year. Now that is remarkable. It almost wants to make you believe in the tooth fairy. We are sure that if we told you on December 31, 2008, that the market was looking for $77 on operating EPS for 2009, but $56 is all we would muster, you wouldn’t have told us that your price forecast for year-end would be 1,115. And here we are today, and the same consensus crew is calling for just about the same level of earnings again — this time for 2010. If the consensus is correct, then the market is sitting very close to fair-value with a 15x forward P/E multiple. If we are right on earnings, then we are looking at over an 18x forward multiple or a market that is overvalued by 22%. Just remember that the equity market is pricing in 5% real GDP growth for the year ahead. We recall all to well in December 1996 when then Fed Chairman Alan Greenspan uttered the words “irrational exuberance” to describe a market that, at the time, was de facto discounting growth of 3.7%. Mr. Greenspan never mentioned those words again, but there was no need to because in 1997 we saw the economy expand 4.5%. So, if in fact we see real GDP advance 5% in 2010, we will eat our words as Mr. Greenspan did 13 years ago. But if the economy falls short of these even loftier expectations ... then be braced for a whole lot of helium to come out of this giant hot air balloon. We’ve known Byron Wien for a long time — he was a formidable competitor while we were both on the sell side and in later years, a valued client and friend while he was on the buy side. He had a pretty good year in 2009, of that there is little doubt. But his just-released list again totally epitomized the consensus view — and it is useful to know this because as Bob Farrell told us in his Ten Commandments of investing, “When all the experts and forecasts agree, something else is going to happen” (the 9th commandment). We won’t reprint Byron’s list here, though we were inundated with our views on it yesterday, but all the ‘surprises’ are on the upside as far as the economy, profits and interest rates are concerned. His whole piece involves world peace, a huge equity rally, massive bond selloff, Fed tightening, a dollar bull market, successful policy action on energy and financial sector reform. Nothing on double dip, deflation, renewed equity slide, Israeli military strike, 10% home price decline, sovereign default risk, Euro-area discord, or a Chinese relapse. These don’t seem to worry Byron — but then again, with the VIX index at 20 … the market seems unperturbed about downside risks as well.

The S&P 500 rallied 23% in 2009 even though earnings for the year came in a whopping $22 a share, or 27% below what was being priced in at the start of the year

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January 5, 2010 – BREAKFAST WITH DAVE

THE NEW FRUGALITY No doubt the incoming economic data in the U.S. are surprising to the high side, like the ISM, but this is all noise around a fundamental trend that is still heading south. Yesterday’s Chicago Tribune ran with an absolutely chilling article titled Recession Could Permanently Scar The Thinking of Americans 18-25. Here are some excerpts … but as Tevya warned Golda after the his staged nightmare, “don’t be frightened!”: “After living through one of the most brutal recessions in U.S. history, many late teens and young adults could be scarred for life, adopting behaviors that could skew everything from their own careers to politics, corporate profits and the stock market. Academics are beginning to study the implications of the recent recession on the current generation of Americans that age, suggesting it may affect them in much the same way the Great Depression turned so many young people of the 1930s into conservative spenders and investors. It is possible that a generation of pre-retirees, and possibly their children, have been scarred permanently by stock market losses. Research by University of California- Berkeley Professor Ulrike Malmendier and Stanford University's Stefan Nagel shows that when individuals have had low stock market returns for many years, they don't want to take risks in stocks. And bad experiences with stocks early in life "have significant influence even several decades later," they said in a research paper. Fidelity Investments research shows that Americans 22 to 33 years old have shifted toward more conservative financial behavior, too. It's influencing everything from investing to job choices.” ISM UP … WITH ONLY HALF THE INDUSTRIES REPORTING GROWTH! The ISM manufacturing index beat consensus views and came in at 55.9 in December from 53.6 in November (market was bracing for 54.3). This is a new recovery high, breaking above the 55.7 mark set in October. The orders-to-inventory ratio ticked up to 1.51x from 1.46x in November and is a sign that production should be firm into the opening months of the year. Good news for the S&P 500 capital goods group. Just about every subindex was up. Notables were orders — 65.5 from 60.3 — best print since December 2004. The employment index rose to 52.0 from 50.8 and will fuel expectations of a flattish nonfarm payroll report on Friday.

The ISM index beat consensus views, coming in at 55.9 in December from 53.6 in November (market was bracing for 54.3). This is a new recovery high, breaking above the 55.7 mark set in October

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January 5, 2010 – BREAKFAST WITH DAVE

If there was anything curious behind the data, it was that the ISM climbs to 55.9 from 53.6 and yet only nine of the 18 industries (50%) posted growth — versus 12 the month before (67%). As with some of the other data we have seen for December, there seems to be some strong seasonal adjustment factors skewing the data (ie, the current factors may be overcompensating in taking into account the dramatic post-Lehman weakness a year ago and adjusting for it). But what got lost in the commotion was the November construction data that was released at the same time … unlike ISM, the monthly construction numbers feed right into GDP and we would look for some trimming around the Q4 consensus forecasts, which are above 4%. October construction spending was revised down to -0.5% MoM from flat; November came in at -0.6% (versus -0.5% expected). The November weakness was broad based — residential at -1.6%; office -0.8%; lodging -1.0%; manufacturing 0.0%. THE NEW NORMAL In the post-bubble credit collapse economy, what was previously unthinkable suddenly becomes the “new normal”. From March 1983 (when the Reagan-led economic expansion took hold) through to September 2008 (when Lehman collapsed) we never once had a month where U.S. vehicle sales came in as low as 11 million units at an annual rate. That is a span of 25 years. In yesterday’s WSJ, page B1, there is a huge article titled Late Surge in Car Sales Raises Hopes for 2009. This “surge” seems to have taken sales up to 11 million units in December (data out later today), which would be up from 10.9 million in November. So here we are today, and it is apparently good news that we had virtually no growth in sales towards the end of the year even with dramatic incentives (according to the article, GM gave its dealers $7,000 for some of its models) and that we had 11 million units when the ‘old normal’ was 16 million units (not to mention that 12 million is the cutoff for replacement demand — autos are still being taken off the highways and driveways of America). SMALL BUSINESS STILL IN A CREDIT QUAGMIRE We mentioned yesterday how this has become the "Late Payment Economy". According to PayNet, the percent of small business loans that have been behind for 180 days or more rose to 0.91% in November from 0.87%. Accounts in arrears for at least 30 days jumped to 4.33% from 4.19%. NO HOUSING RECOVERY One would think that of all the sectors that should be benefiting from all the government largesse it would be housing — but at 355k in November, new home sales were down 11% MoM and the fifth lowest level in 3 decades. It is now taking the builders a record 14 months to locate a buyer upon completion of a unit. And the unsold inventory shot back up to 7.9 months’ supply from 7.2 in October. Sales of completed homes are still down 38% from what were already depressed levels of a year ago.

With all the commotion about the ISM, what was masked in yesterday’s data release was construction spending, which came in below expected in November and underwent a big downgrade in the October figures

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January 5, 2010 – BREAKFAST WITH DAVE

CHART 2: NO HOUSING RECOVERY IN THE U.S.
United States: New Single-Family Home Sales (thousands, annualized)
1400 1200

1000

800 600

400

200 65 70 75 80 85 90 95 00 05
Shaded region represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

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January 5, 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
As of September 30, 2009, the Firm managed assets of $5.0 billion.

INVESTMENT STRATEGY & TEAM

We have strong and stable portfolio management, research and client service teams. Aside from recent additions, our Gluskin Sheff became a publicly traded Portfolio Managers have been with the corporation on the Toronto Stock Firm for a minimum of ten years and we Exchange (symbol: GS) in May 2006 and have attracted “best in class” talent at all remains 65% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and We have a strong history of insightful governance with a private company bottom-up security selection based on commitment to innovation and service. fundamental analysis. Our investment interests are directly 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, client of the Firm’s investment portfolios. shareholder-minded management and a share price below our estimate of intrinsic We offer a diverse platform of investment value. We look for the opposite in strategies (Canadian and U.S. equities, equities that we sell short. Alternative and Fixed Income) and investment styles (Value, Growth and For corporate bonds, we look for issuers 1 Income). with a margin of safety for the payment of interest and principal, and yields which The minimum investment required to are attractive relative to the assessed establish a client relationship with the 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) 2 Our success has often been linked to our would have grown to $15.5 million on long history of investing in underSeptember 30, 2009 versus $9.7 million followed and under-appreciated small for the S&P/TSX Total Return Index and mid cap companies both in Canada over the same period. and the U.S. $1 million usd invested in our U.S. PORTFOLIO CONSTRUCTION Equity Portfolio in 1986 (its inception date) would have grown to $11.2 million In terms of asset mix and portfolio 2 usd on September 30, 2009 versus $8.7 construction, we offer a unique marriage million usd for the S&P 500 Total between our bottom-up security-specific Return Index over the same period. fundamental analysis and our top-down macroeconomic view.
Notes:

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.

$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) would have grown to $15.5 million2 on September 30, 2009 versus $9.7 million for the S&P/TSX Total Return Index over the same period.

For further information, please contact questions@gluskinsheff.com

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.

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January 5, 2010 – BREAKFAST WITH DAVE

IMPORTANT DISCLOSURES
Copyright 2010 Gluskin Sheff + Associates Inc. (“Gluskin Sheff”). All rights reserved. This report is prepared for the use of Gluskin Sheff clients and subscribers to this report and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Gluskin Sheff. Gluskin Sheff reports are distributed simultaneously to internal and client websites and other portals by Gluskin Sheff and are not publicly available materials. Any unauthorized use or disclosure is prohibited. Gluskin Sheff may own, buy, or sell, on behalf of its clients, securities of issuers that may be discussed in or impacted by this report. As a result, readers should be aware that Gluskin Sheff may have a conflict of interest that could affect the objectivity of this report. 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