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Breakfast With Dave 101310

Breakfast With Dave 101310

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

com + 1 416 681 8919

October 13, 2010 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave
WHILE YOU WERE SLEEPING The risk-on trade is back with the equity market even more comfortable now that QE2 is on its way after sifting through yesterday’s FOMC minutes. The fact that the Fed staffers, yet again, took a knife to the macro outlook did not even register a yawn. So we have a market backdrop completely dependent on sentiment and psychology as the P/E multiple expands and at the same time a market backdrop that has become unglued from economic reality. The Fed is so desperate that it is even contemplating measures that would attempt to boost inflation expectations — nice in theory, but in practice this may be difficult. Totally experimental, but Mr. Market seems to be putting blind faith in the Fed as it did back in the fall of 2007. As far as today’s market action, the key correlation of course is with the U.S. dollar, which is heading back south, but at the same time, so are the yen and Swiss franc — the other defensive currencies. The euro is bid as signs continue to emerge that no more easing is coming out of the ECB — France’s inflation rate rose to 1.8% in September from 1.6% on the back of the food complex. And, the emerging market currency complex is firm today as well — ditto for the commodity currencies as the loonie and Aussie dollar continue on in their race towards “par”. CDS spreads are tightening overseas as perceived corporate default risks recede further. Meanwhile, in the global equity market, it is a literal sea of green right across the screen — back to six-month highs for the MSCI World Index. The other news that lifted confidence was the trade report showing that China’s exports jumped 25% in September and Japanese machinery orders soared 10.1% in August (there was also a 3.3% rebound in Australian consumer sentiment). The post-data backup in JGB yields have been transmitted to other sovereign bond markets in the wee hours of the morning. The commodity sector is gaining ground with the U.S. dollar back in retreat mode. Copper is testing 27-month highs, the entire food complex is rallying again, and gold is just 0.4% shy of making a new all-time high. Oil is recovering on the back of an increase in the IEA forecast for global demand (by 300,000 barrels per day for this year and next — to 86.9 million barrels per day, and 88.2mbd, respectively) as well as the news that China imported a record 23.3 million metric tons of crude last month. IN THIS ISSUE • While you were sleeping: the risk-on trade is back with the market even more comfortable now that QE2 is on its way after sifting through yesterday’s FOMC minutes • Some sector screens based on low correlations to U.S. growth, high correlations to emerging market growth, decent yield and attractive P/Es • Small business, small confidence level: the NFIB small business optimism survey just came out and confidence is still at recessionary levels • What’s ahead in Q3 earnings season? The consensus is looking for 24% YoY earnings growth in the U.S.; revenues are seen lagging behind once again; profit growth is slowing down, but consensus estimates are probably still too high

Please see important disclosures at the end of this document.

Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to meeting the needs of our clients by delivering strong, risk-adjusted returns together with the highest level of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports, visit www.gluskinsheff.com

October 13, 2010 – BREAKFAST WITH DAVE

The politics may well be turning more positive for the markets as well; we see two developments that suggest as much. The White House said it is backing off from any plans to impose a moratorium on home foreclosures (what the industry decides to do is its business). And, President Obama just lifted the ban on deepwater drilling. Bill Clinton is increasingly on his way towards being the Democrats’ “white knight” as election day approaches (see page 5 of the FT) and who knows how to move to the middle better than him. Who knows? If the President is already showing signs of flexibility and can manage to pull a few feathers out of Mr. Clinton’s cap, perhaps the Bush-era dividend, capital gains and ‘high-income’ tax rates will see a post-2010 reprieve. For a sentiment-driven market, this would likely be important. A must-read today is Martin Wolf’s column on page 11 of the FT — Why America is going to Win the Global Currency Battle. To wit: “The global consequences are evident: the policy will raise prices of long-term assets and encourage capital to flow into countries with less expansionary monetary policies (such as Switzerland) or higher returns (such as emerging economies). This is what is happening. The Washington-based Institute for International Finance forecasts net inflows of capital from abroad into emerging economies of more than $800bn in 2010 and 2011. It also forecasts massive intervention by recipients of this capital, albeit at a falling rate.” Also see The Currency Race That Everybody is Trying to Lose on page 25 for why gold is likely going to make new higher highs. The Fed is pushing on a string and is in a classic liquidity trap but the markets love the prospect of more reserves flowing into risk assets even if the economy is left in the dust. In this respect, the quote of the day goes to former Dallas Fed President Mike McTeer on page B2 of the NYT regarding the move afoot to QE2 — “If you lead the horse to water and it won’t drink, just keep adding water and maybe even spike it …” Yikes! This will not end well, even if it is next to impossible to say when it does. Page C1 of the WSJ runs with Fed Moves Viewed as Softening the Dollar. The article posits that “Investors increasingly believe the U.S. is putting itself at the forefront of the competitive devaluation race. That view is driven in part by the Treasury’s increased pressure on China to allow its currency to rise against the dollar, which would likely result in the dollar falling against a range of other emerging market currencies.” Since 1985, dollar-yen has sunk nearly 70% and yet the US has the same bilateral deficit with Japan today as it had then. So why does everyone think that a Chinese revaluation will necessarily clear out any perceived imbalances? Maybe if U.S. policy encouraged thrift over asset-based consumption growth, these trade imbalances would dissipate more quickly.

Bill Clinton is increasingly on his way towards being the Democrats’ “white knight” as election day approaches (see page 5 of the FT) and who knows how to move to the middle better than him

The Fed is pushing on a string and is in a classic liquidity trap but the markets love the prospect of more reserves flowing into risk assets even if the economy is left in the dust

Page 2 of 8

October 13, 2010 – BREAKFAST WITH DAVE

And the front page of the WSJ has this as a lead article — Fed Chief Get Set to Apply Lessons of Japan’s History. While there are differences, “the similarities between the two economies are striking.” The article dusts off a speech that Ben Bernanke gave over a decade ago on Japan’s policy paralysis and one of his suggestions was to “cheapen the yen” as well as to “buy long-term debt”. This certainly seems to be the current roadmap in the U.S.A. Finally, an article that truly resonates with us — from the front page of the NYT (Across the U.S., a Long Recovery Looks Much Like a Recession). For how long the equity market can become unglued from the real economy remains to be seen, but there is little doubt in our mind that it is going to take years to repair all the damage and absorb all the excess supply (of homes, office buildings, plants and labour). The article is well worth a read, regardless of your market view. SOME SECTOR SCREENS While getting the asset mix right is always extremely critical, so is getting the sectors right within the equity allocation. With this in mind, what makes sense is to own the sectors that have this combination of characteristics: 1. Low correlations to the sluggish U.S. economic growth profile. 2. High correlations to the stronger emerging market growth profile. 3. Comparable or better dividend yield than you can get in the bond market. 4. Below average P/E ratios in the search for relative value. The sectors that stand out as possessing the best attributes after running screens on the above-mentioned factors (for both Canada and the United States) are Staples, Health Care and Energy, followed closely by utilities. The sectors that screened poorly were Industrials, consumer discretionary and financials. SMALL BUSINESS, SMALL CONFIDENCE LEVEL The National Federation of Independent Business (NFIB) survey came out for September and it was predictably soft — edging up fractionally to 89.0 from 88.8 in August. To put that number in context, it was 92.9 in September 2008 when Lehman collapsed; it was 96.3 on September 2001 when the terrorist attacks occurred; and it was 99.5 in September 1998 when the Fed was forced to bail out LTCM and Russia defaulted. This is a recessionary level; that is for sure. But as usual, the devil was in the details:

While getting the asset mix right is always extremely critical, so is getting the sectors right within the equity allocation

Despite the fractional increase, small business sentiment in the U.S. remains at recessionary levels

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

Page 3 of 8

October 13, 2010 – BREAKFAST WITH DAVE

CHART 1: NO PLANS ON A HIRING SPREE FROM SMALL BUSINESSES
United States: National Federation of Independent Business Small Business Optimism Survey: Percentage Planning to Increase Employment (net, percent)
20 15

10

5

0

-5

-10 04 05 06 07 08 09 10

Source: Haver Analytics, Gluskin Sheff

• •

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

CHART 2: SMALL BUSINESSES NOT LOOKING TO INCREASE WAGES
United States: National Federation of Independent Business Small Business Optimism Survey: Percentage Planning to Raise Worker Compensation (net, percent)
20

16

12

8

4

0 04 05 06 07 08 09 10

Source: Haver Analytics, Gluskin Sheff

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

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

Page 4 of 8

October 13, 2010 – BREAKFAST WITH DAVE

WHAT’S AHEAD IN Q3 EARNINGS SEASON?
• • • •

The consensus is looking for +24% YoY earnings growth. Revenues are seen lagging behind once again, at +7%. Strip out financials and operating EPS growth is seen at a more modest +18% (half the pace of the first half of the year). Profit growth is slowing down, but not collapsing. That said, consensus estimates are probably still too high.

When profit margins are at a cycle high, we find that on average, profits invariably end up lagging well behind nominal GDP growth

Two wild cards could be reduced guidance from the Tech and Transports sectors — we say that because of the comments on these two sectors coming out of the recent ISM survey: Computer & Electronic Products: “Strategic customers reducing order quantities.” Transportation equipment: “Customers seem to be pulling back on orders. I suspect that they are trying to reduce their inventory for the approaching yearend.” Going forward, here is the challenge. The consensus is still looking for $95plus on U.S. operating EPS growth for 2011, but at a time when profit margins are at a cycle high, not a trough. There is a difference. At troughs in margins, profits, on average, expand at six times the pace of nominal GDP growth in the ensuing year. But when margins are at a cycle high, we find that on average, profits invariably end up lagging well behind nominal GDP growth and, in fact, decline in the next year by 3% on an average basis, and close to 5% on a median basis. As a result, it may be more prudent at this juncture to be valuing the equity market on $75 of S&P 500 operating earnings next year than on $95. Slap on an appropriate multiple and you can see why an underweight position still makes sense, speculative QE2 fervor notwithstanding. All we know is that in the aftermath of the very soft ISM and nonfarm payroll reports for September, double-dip risks, as they pertain to the U.S. economy, have not exactly disappeared. So it would stand to reason that an equity investor would rather own sectors that have low as opposed to high correlations with the U.S. economy. The sectors with the highest correlations are industrials, financials and technology. The sectors with the lowest correlations are health care, energy and utilities. What’s even better is that the first group has an average dividend yield of 1.2% while the latter is 3.5%. So not only does the latter group have lower exposure to the uncertain U.S. business cycle, but it carries a 230 basis point dividend yield premium. The latter group of more defensive sectors also has an average earnings yield of 7% versus 5% for the former group of segments more geared to the domestic economic backdrop.

In the aftermath of the very soft ISM and nonfarm payroll reports for September, double-dip risks, as they pertain to the U.S. economy, have not exactly disappeared

Page 5 of 8

October 13, 2010 – BREAKFAST WITH DAVE

In our work, Energy and Health Care are among two of the most undervalued equity sectors at the current time; Financials and Materials, two of the most expensive. As for the overall U.S. equity market, our propriety fair-value model moved down to 1,050 in the past month from 1,070, with regard to the S&P 500. The range is 1,000 to 1,120 so the index has moved above the top end of the band. This suggests an overvaluation of around 10% — the last time it was this overvalued was late last year; the Shiller normalized P/E ratio is now pointing towards a near-30% degree of overvaluation; a Tobin-Q model that looks at replacement-historical costs indicates a 20% level of overvaluation. In a nutshell, this market is no bargain at today’s prices. What stood out in the past month was that the stock market surged even as analysts cut their EPS forecasts, generating P/E expansion, presumably on QE2 hopes. With respect to the TSX, our fair-value estimate also declined, to 10,785 in the past month even as the market melted up — now about 16% overvalued from where the market is trading today (range of 10,380 to 11,090). There was a modest decline in earnings estimates, both trailing and forward. The most undervalued sectors are a little different than in the U.S.A. — staples, Tech and Telecom; Materials, Utilities and Financials are the most expensive. In terms of the fixed-income market, our work still finds corporate bonds to be attractively priced, on average, with BB rated bonds still the most undervalued slice. Our main model incorporates BBB-rated product and it suggests that we would still have 80bps of spread tightening to go before hitting fair-value levels. The high yield market is better priced than investment grade right now — that story has not changed. The Canadian dollar is now 99 cents (U.S.) while our fair-value estimate is stuck at 91.5 cents. The last time the loonie was this far overvalued was back in the third quarter of 2008. No doubt it took an “event” (like a “black swan”) to knock the loonie off its perch back then, but suffice it to say, it is more vulnerable to downside surprises from here than it is susceptible to any substantial upside potential. In other words, despite the positive momentum and the “good news” Canada story, the risks for the Canadian dollar from here, at least over the near-term, seem to be pretty one-sided.

Despite the positive momentum and the “good news” Canada story, the risks for the Canadian dollar from here, at least over the near-term, seem to be pretty one-sided

Page 6 of 8

October 13, 2010 – BREAKFAST WITH DAVE

Gluskin Sheff at a Glance
Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted investment returns together with the highest level of personalized client service.
OVERVIEW
As of June 30, 2010, the Firm managed assets of $5.5 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 54% 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 For corporate bonds, we look for issuers investment styles (Value, Growth and 1 with a margin of safety for the payment Income). 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 $10.9 million on 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. Equity Portfolio in 1986 (its inception date) would have grown to $10.9 million 2 usd on June 30, 2010 versus $8.6 million usd for the S&P 500 Total Return Index over the same period.
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 $10.9 million2 on June 30, 2010 versus $5.4 million for the S&P/TSX Total Return Index over the same period.

PORTFOLIO CONSTRUCTION
In terms of asset mix and portfolio construction, we offer a unique marriage between our bottom-up security-specific fundamental analysis and our top-down macroeconomic view.
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.

Page 7 of 8

October 13, 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. This report should not be regarded by recipients as a substitute for the exercise of their own judgment and readers are encouraged to seek independent, third-party research on any companies covered in or impacted by this report. Individuals identified as economists do not function as research analysts under U.S. law and reports prepared by them are not research reports under applicable U.S. rules and regulations. Macroeconomic analysis is considered investment research for purposes of distribution in the U.K. under the rules of the Financial Services Authority. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person. Investors should seek financial advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Any decision to purchase or subscribe for securities in any offering must be based solely on existing public information on such security or the information in the prospectus or other offering document issued in connection with such offering, and not on this report. Securities and other financial instruments discussed in this report, or recommended by Gluskin Sheff, are not insured by the Federal Deposit Insurance Corporation and are not deposits or other obligations of any insured depository institution. Investments in general and, derivatives, in particular, involve numerous risks, including, among others, market risk, counterparty default risk and liquidity risk. No security, financial instrument or derivative is suitable for all investors. In some cases, securities and other financial instruments may be difficult to value or sell and reliable 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 coplaintiffs 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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