David A.

Rosenberg March 29, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave

PLEASE NOTE THAT WE WILL NOT BE PUBLISHING IN THE NEXT TWO DAYS.
THE NEXT PUBLICATION DATE IS THURSDAY, APRIL 1 IN THIS ISSUE
• Market thoughts — I know
MARKET THOUGHTS what a broken record
sounds like and this has
Well, well, the theory that the stock market has turned in a double top may not
been a confounding and
have gone the way of the Dodo after all, following the reversals we saw in the confusing market — for
last two trading days of last week. Negative reversals and distribution days in both the bears and many
three of the last six sessions is something to be concerned about if you are long (though not all) of the
this market — and volume remains tepid at best. bulls
• What’s on the worry list?
The market is now overvalued by over 25% but is also extremely overbought April is a key month, no
having gone 24 sessions without a decline of 1% or more, and 89% of the stocks fooling
in the S&P 500 are now trading above their 50-day moving averages (see page • Who will buy U.S. bonds?
M3 of Barron’s). The Dow has advanced in 17 of the past 21 days. I mean, Sentiment is so negative
even if you are bullish on the outlook, one would have to admit that such a on the U.S. Treasury
parabolic move is vulnerable to at least a modest pullback… or more. I know market it’s not even funny
what a broken record sounds like and this has been a confounding and anymore
confusing market — for both the bears and many (though not all) of the bulls. • U.S. savings rate slide
spurs spending
Looking at the fund flows, there is only one conclusion that can be reached: This • Why Canadian
market is being driven by pig farmers. Retail inflows may have picked up of late, commercial real estate is
but only fractionally. The focus on the part of the individual investor remains on still so firm
the fixed-income market, for better or for worse (better from our standpoint, • U.S. earnings update —
worse from the standpoint of my friend and fellow debater Jim Grant). bottom-up analysts are
expecting another good
Institutional portfolio manager cash ratios are back to the rock bottom levels of quarter of earnings in Q1
around 3½% — where they were back at the market peak in October 2007. The • My take on the U.S. Q4
shorts have all but been covered. Foreign investors have been few and far GDP report
between, based on the latest TICS data. The lack of volume speaks volumes —
• Show me the money!
there are no sellers. Investors of all types have been content to just sit and
watch their equity position expand via the price appreciation, but there is scant
evidence of any follow-through this year in terms of volume buying.

So, that leaves me with a suspicion that the entities doing the buying are the pig
farmers. Who are they pray tell? They are the prop desks at the five large
banks. They buy and sell securities, with leverage ... to each other! And, these
transactions often occur late in the day or in the futures pit after the market
closes. There is no sign of any other buyer out there, including the Fed who has
been too busy choking on mortgage backed securities and Maiden Lane assets.
To repeat, that is why the volumes have been so low.

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March 29, 2010 – LUNCH WITH DAVE

What we should be aware of about the pig farmers is that they could, at any
time, flick the switch in the other direction. What the “trapped longs” may be It is always difficult to
forced to do — the ones that have been sitting on their hands and have been predict the future, but so
waiting for the bear market rally to take their portfolio back to where it was at many investors are
the peaks — at that point is start to sell. That is when the volume picks up ... caught in the moment
and accelerates the downside pressure.

Of course, it is always difficult to predict the future, but so many investors are
caught in the moment and are being told “not to fight the tape” and simply play
the momentum game. They do not see that the current rebound in the economy
is a statistical mirage orchestrated by record amounts of monetary and fiscal
stimulus that are simply unsustainable and actually risk precipitating a very
unstable financial and economic backdrop in coming years.

From our lens, the rally of the last 12 months smacks of the 1930 snapback,
and if memory serves us correctly, the S&P 500 went on to hit new lows in
subsequent years and the next secular bull market did not start until 1954. I
am sure that all the bullish pundits and ‘tape watchers’ were ridiculing the
cautious folks back then — just go and have a look at the Diary of Benjamin Roth
and you will see how much giddiness there was over the bear market rally and
that the worst was over back then. Meanwhile, the lows were still more than a
year away to everyone’s surprise — except those who kept their eyes on the
forest, not the trees.

Deleveraging cycles take years to play out, even with massive doses of
government intervention.

In today’s context, once again few, if any, will know when we reach the peak
since there is no perfect market-timer out there that we know of. But the
pattern of the past 12 years, when Alan Greenspan embarked on the bailout
path with LTCM back in 1998, and the roller-coaster ride that ensued since, it
has been just as prudent to take profits after a 70% bounce as it would have
been to start adding to equity positions after a 50% decline.

It is clear from the volumes of emails I receive daily that there is frustration
among those who think they have somehow missed something important by not
being overweight cyclical stocks over the past year. The tone of the responses
to my daily musings is eerily similar to the complaints I saw frequently back in
2006 and 2007 — and the advice not to “fight the tape” or to “fight the Fed”.
These are just glib after-the-fact excuses for going long the market when nobody
really has a good idea on why we should be bullish in the first place.

We hate to break it to the bulls but even with the pleasant rally in risk assets
over the past year, there really is nothing to be bullish about when it comes to
how the economy is performing now or in the future as all the monetary and
fiscal largesse is unwound. Have a look at States Look to Tax Services, From
Head to Toe on the front page of the Sunday NYT, as well as Moves to Tax Banks
to Pay for Bailouts Gain Steam on page C1 of today’s WSJ.

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As an aside, if the Administration does not enact a new tax law, the tax rate on
dividends reverts to the pre-2001 rates, which are the same as rates on ordinary What we have to
income — 39.60% at the top bracket. Recall that by the time the 1930s came to constantly remind
an end, FDR paid for the massive fiscal expansion by lifting top marginal tax ourselves is that we are
rates, to 80%. still in a secular bear
market …
What we have to constantly remind ourselves is that we are still in a secular
bear market, that the S&P 500, through all the numerous peaks and valleys, is
still in the hole to the tune of 25% over the past decade, that we are in the
classic Bob Farrell stage 2 of the long cycle, which is the “reflexive rebound”
phase, and that frankly, there is really no reason to add undue risk to the
portfolio except perhaps for the most ardent day-trader.

It’s remarkable how so many people still refuse to accept what history has
taught us about post-bubble credit collapses — they do indeed require ongoing
government support, but even then we endure five to seven years of economic
stagnation. And, that flat line will involve periods of growth followed by periods
of contraction but the lasting theme is one of volatility.

For a long while, I have recommended that investors have a read of “The Great
Depression: A Diary.” It is the story of Benjamin Roth (a Youngstown lawyer) — the
only detailed personal account of the 1930s that has been published. On July 31,
1931, he entered this into his journal: “Magazines and newspapers are full of
articles telling people to buy stocks, real estate etc. at bargain prices.” Of course,
this was right during the “reflexive rebound” and the market still had 35% to go on
the downside before the triple waterfall bear market was complete.

On March 6, 1933, he lamented that “When I started in 1930 to jot down the
happenings during the depression I had no idea it would last as long and I did
not think I would require more than one small notebook. Now after 3½ years of … Through all the
the worst depression has even seen, the end is not in sight.” numerous peaks and
valleys in the market,
It is very important not to get caught up in the euphoria in the business media the S&P 500 is still in
and the mania in the financial markets. The most dangerous thing anyone can the hole to the tune of
do right now is extrapolate the stimulus-led bounce of the past year into the 25% over the past
future. As Mr. Roth’s diary shows, these post-bubble bouts of giddiness were decade
not sustained, even with the New Deal.

As was the case back then, the investors who end up succeeding are not the
ones who are able to play the flashy bear market rallies but the ones who opt for
strategies that minimize volatility and optimize risk-adjusted returns. Income,
whether it be from paper assets (bonds, dividends) or hard assets (oil and gas
royalties, REITs), is going to emerge as king in an environment where the primary
trend is one of deflation, which is indeed the case as private sector credit
contracts.

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The U.S. dollar has been strengthening, gold is sputtering, rents are declining,
wages decelerating, core consumer prices flattening and now money supply
growth is vanishing. It may take the equity market time to absorb all of this, but
for those who believe that at some point the economic fundamentals will come
to dominate the landscape, it may pay to gaze at the charts below that depict
the current economic cycle relative to the average of its predecessors. These
charts show everything from real GDP, to real final sales, to employment, to
industrial production, to retail sales, to housing and it is plain to see that this
goes down as the weakest post-recession recovery on record despite the fact
that it is being underpinned by the most intense level of government support on
record. That indeed is cause for pause.

CHART 1: NOT YOUR TYPICAL RECOVERY — REAL GDP

United States
(data indexed to 100 = start of recession)
Represent average length of a recession
105
Expansion Phase
104

103

102

101

100

99
End of Current Recession
98

97

96 Recession
95
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Number of Months from the Start of Recession

Source: Haver Analytics, Gluskin Sheff

CHART 2: NOT YOUR TYPICAL RECOVERY —FINAL DOMESTIC SALES

United States: Real Final Domestic Sales
(data indexed to 100 = start of recession)
Represent average length of a recession
106
Expansion Phase
105

104

103

102

101

100
End of Current Recession
99

98
Recession
97
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Nu m b e r o f M o n th s fr o m the Sta r t o f R e ce ssi o n

Source: Haver Analytics, Gluskin Sheff

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CHART 3: NOT YOUR TYPICAL RECOVERY — EMPLOYMENT

United States: Nonfarm Payrolls
(data indexed to 100 = start of recession)
Represent average length of a recession
101
Expansion Phase
100

99

98

97

96 End of Current Recession

95

94 Recession

93
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Number of Months from the Start of Recession

Source: Haver Analytics, Gluskin Sheff

CHART 4: NOT YOUR TYPICAL RECOVERY — INDUSTRIAL PRODUCTION

United States: Industrial Production
(data indexed to 100 = start of recession)
Represent average length of a recession
103
Expansion Phase
101

99

97

95

93

91

End of Current Recession

89

87
Recession

85
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Number of Months from the Start of Recession

Source: Haver Analytics, Gluskin Sheff

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CHART 5: NOT YOUR TYPICAL RECOVERY — RETAIL SALES

United States
(data indexed to 100 = start of recession)
Represent average length of a recession
110
Expansion Phase
108

106

104

102

100

98

96 End of Current Recession

94

92

90 Recession

88
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Number of Months from the Start of Recession

Source: Haver Analytics, Gluskin Sheff

CHART 6: NOT YOUR TYPICAL RECOVERY — HOUSING STARTS

United States
(data indexed to 100 = start of recession)
Represent average length of a recession
130
Expansion Phase
120

110

100

90

80
End of Current Recession
70

60

50
Recession

40
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Number of Months from the Start of Recession

Source: Haver Analytics, Gluskin Sheff

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March 29, 2010 – LUNCH WITH DAVE

WHAT’S ON THE WORRY LIST?

April is a key month, no fooling:

• Last week’s bond auctions did not go well. It seems that Japan and China did April will be a key month
not show much interest. The lack of bids was no better underscored than in … no fooling
the 7-year Treasury note auction where the median yield was 3.29% versus
3.05% a month earlier. April is a cruel month for the U.S. Treasury market,
with 10-year yields rising in each of the past 4 Aprils and in 6 of the past 7,
and by an average of 25 basis points. (As Alan Greenspan said on Bloomberg
News last week, higher yields are “the canary in the mine”.)
• That, in turn, could spook the equity market since another 25bps of upside
pressure could then generate a fund-flow spiral as was the case in the
summer of 2007 — 3.85% (where we are now) ostensibly is a trigger point for
selling of mortgage bonds. As rates rise, homeowners are less likely to pay
their mortgages early, which extends the life of the mortgage and that in turn
encourages mortgage investors to neutralize the duration of their portfolios by
selling T-bonds and notes. We have seen this happen before and while it will
likely provide a nice buying opportunity given the deflationary headwinds the
economy now faces, the prospect of a spasm in the Treasury market is worth
considering. Every equity market correction in the past — 1987, 1994, 1998,
2000, and 2007 — was preceded by what turned out to be a brief but
significant runup in yields. See Stock Rally at Mercy of Rising Rates on page
C1 of today’s WSJ). And, the more overvalued the equity market is, the more
the downside risks if bonds begin to provide greater yield competition in the
near-term. Jeffery Hirsch over at the Stock Trader’s Almanac is in today’s NYT
predicting a 20-30% correction ahead (see Stocks Soar, But Many Ask Why on
page B1) — he notes the modest number of stocks hitting new 52-week highs
with every new interim peak being reached by the overall market.
• The leading indicators are all pointing to a slowdown, and this could show up in
a critical data-release week in mid-April with retail sales on the 14th, industrial
production on the 15th, and housing starts, as well as consumer sentiment, on
the 16th. The broad money supply measures are contracting again as the Fed is
no longer boosting its balance sheet at a time when both the money multiplier
and money velocity are showing no signs of turning higher.
• Greece will be put to the test in April when €15 billion of bonds have to be
rolled over (through the end of May).
• The Fed ceases to buy mortgage securities on Wednesday and this is
happening at a time when mortgage rates have already climbed back above
5% and the housing market is showing signs of rolling over again. See Spike
in Treasury Yields Jolts Mortgages on page C2 of today’s WSJ. There is also
pressure from within the Fed (Plosser the latest) to soon begin to sell
securities outright. One thing that is very likely on its way again is another
50bps hike on the discount rate — has anyone noticed the TED spread
beginning to widen ahead of this? The banks, going forward, will not have
easy access to the window and will have to rely on each other for funding.

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• April 15 looms as a critical day from a geopolitical standpoint. It is the day that
the Treasury Department will issue its report concluding whether or not China is Sentiment is so negative
a currency manipulator. If it is viewed as such then trade sanctions are likely to on the U.S. Treasury
ensue and very likely some bilateral tensions. This could be very good news for market it’s not even
the bullion market (as well as the Bloomberg News report today stating that gold funny. Everyone seems
imports in India are surging right now — up six-fold from a year ago — as there to focus strictly on
are an expected 1 million marriages planned for April and May). supply without realizing
that the only way to
• Speaking of geopolitical risks, President Obama has allowed U.S. relations with predict a price is by
Israel to deteriorate to such an extent, and is handling the Iran nuclear situation forecasting both supply
with such a kid-gloves approach, that disturbing columns like this are now and demand
popping up in newspapers like the NYT (Rift Exposes Larger Split In Views On
Mideast — page A4), the National Post (Iran Preparing to Build Two More Secret
Nuclear Sites in Mountains, Experts Say — page A8), and the WSJ (How the Next
Middle East War Could Start — page A23). Even the prospect is enough to
underpin the energy stocks, which are currently priced for $69/bbl on WTI.

WHO WILL BUY U.S. BONDS?

Sentiment is so negative on the U.S. Treasury market it’s not even funny.
Everyone seems to focus strictly on supply without realizing that the only way to
predict a price is by forecasting both supply and demand. On its own, supply looks
worrisome given the Administration’s bent on running huge fiscal deficits (and it
just unveiled a new set of initiatives to reverse the foreclosure crisis).

What is ignored in so much analysis is the demand side of the equation — boomer
households, for example, have only 6% of their assets in bonds versus nearly 30%
in real estate and equities. They have about $8 trillion that they can put to use
towards income-oriented portfolio strategies and in fact this powerful demographic
trend is already underway. The banking sector is sitting on $1.3 trillion in cash
and if it ever decided to play the yield curve, as it did coming out of the credit
crunch of the early 1990s, it too could provide up to a trillion dollars of support for
the bond market (even if Bill Gross sits on the sidelines).

Finally, it may pay to have a look at what is happening at the State and local
government level when it comes to unfunded pension liabilities and the
modifications that are coming from the General Accounting Standards Board
(GASB). The era of relying on 8% return assumptions are no longer tenable in
a world of sub-4% nominal GDP growth. Looking at the latest Fed Flow of
Funds report, State and local government pension funds are sitting on an
equity allocation of nearly 60%, but only have 6.5% of their financial assets in
treasury, notes and bonds.

From the mid-1960s up until the mid-1990s, the bond share was consistently
between 20-30% and moving back into this range would involve roughly $500
billion of an allocation shift towards the fixed income market. I highly urge
everyone to read the article on page A2 of today’s WSJ titled Showing the
Woes in Public Pensions.

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Ignoring the demand for fixed income product would have left you with a Run-down in the U.S.
dramatically incorrect forecast of where JGB yields were headed in the savings rate funded the
aftermath of its credit collapse two-decades ago. There were at least seven 0.3% consumer
spasms to the upside, but the primary trend in bond yields was down. spending rate in
February
SAVINGS RATE SLIDE SPURS SPENDING
U.S. consumer spending rose an as-expected 0.3% MoM in February, even
though there was no growth in disposable income. So, the gain was funded by
a rundown in the savings rate, which went from 3.4% in January to 3.1% — just
as the +0.4% print in January was underpinned by a drop in the savings rate
from 4.0% to 3.4%. At 3.1%, the savings rate is all the way back to levels last
seen in October 2008. At play seems to be the effects of lower gasoline prices
during the month as well as the prospect that the wave of strategic defaults
has left consumers with enough cash flow to propel consumption at a 1%
annual rate on its own.

Based on what is built in already, it looks as through real consumer spending

is on track for a near 3% annualized gain in Q1, which would be double what
we saw in Q4 of last year. But there are an array of offsets, from sharply
slower capex growth, depressed commercial construction and the renewed
turndown in the housing market. It looks like the economy will eke out
something close to a 2½% annual rate this quarter as this still goes down as
one of the weakest post-recession recoveries in real final sales ever recorded
despite all of the fiscal and monetary stimulus in the system.

If you do the math, it is fascinating (and disturbing) to see that if not for the
rundown in the savings rate, consumer spending would have been negative in
both January and February — and the ‘build in’ for Q1 would be -0.6% annual
rate (as opposed to +3%).

It would be more encouraging if the spending data were being funded by

organic income growth, but that is not happening — at least not yet. Despite
the so-called improvement in labour market conditions in February, wages and
salaries were flat, and outside of government support, fell 0.2% for the second
month in a row. Real personal income excluding government transfers is one
of the four main components that comprise the NBER’s formula for
determining whether the economy is in recession or expansion and it covers
about two-thirds of the economy — it remains squarely in recession terrain.

The savings rate was 6.4% last May and running this down by half has
certainly given the household sector some leeway to continue to spend as has
been the case. But with fiscal and monetary support in the process of
subsiding, even with the improvement in the jobs market, the lack of income
growth and the depleted savings rate point to a subdued spending pattern
ahead. This was confirmed by the recent downleg in the UofM consumer
expectations survey, which is down to a four-month low and is foreshadowing
a 1.0-1.5% consumption trend in the next two quarters.

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The bond market is obviously going to be a possible headwind for equities if the
backup in yields persists. Much of the spasm is technical in nature — there is
certainly nothing to be concerned about with regard to the inflation background,
and it is inflation that ultimately drives the trend in bond yields, not fiscal policy.
Not only have wages stagnated in two of the past three months, but the PCE
deflator, both the headline and the core (which excludes food and energy), came
in flat in February. While the CPI is maligned for having too strong a weighting in
housing, the PCE deflator does not share this “problem” and the core index is
now running at a mere 1% annual rate over the past three months — down from
the 1.5% trend at the end of 2009.

The Commerce Department also publishes a ‘market based’ PCE number, which
excludes prices that the government “imputes”. On this score, underlying
inflation has been falling even faster — +0.3% at annual rate over the past three
months and at +1.2% YoY, it is now at the slowest pace since September 2003
when the unemployment rate was around 6%, not 10%.

CHART 7: LOOK WHERE UNDERLYING INFLATION IS HEADING

United States: Market Based PCE: Excluding Food & Energy
(year-over-year percent change)

5.25

4.50

3.75

3.00

2.25

1.50

0.75
90 95 00 05

Source: Haver Analytics, Gluskin Sheff

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WHY CANADIAN COMMERCIAL REAL ESTATE IS STILL SO FIRM

We are not talking about residential real estate, which is in some form of a
bubble, especially in Toronto and Vancouver. But anecdotally, commercial In Canada, the
real estate is holding in very well and one of the reasons could well be foreign
commercial real estate
market is holding in very
expansion into Canada.
well compared to the
residential sector, which
For a sign of what is happening in the retail sector, as one example, have a
is in some form of a
read of the article on page B4 of today’s WSJ (U.S. Apparel Retailers Map an
bubble
Expansion to the North). What does Canada offer to American companies who
want to grow but cannot do it without moving aggressively to gain market
share in an oversaturated U.S. backdrop? Well, as the article asserts, Canada
offers “a way to expand internationally but in a market that’s closer and more
familiar than Europe or Asia.”

The prospect of more U.S. money being put to work north of the border is of
course also long-term bullish for the Canadian dollar, which may be
overvalued now by about a nickel; however, at the same time, the fair-value
line keeps moving higher, which is a hallmark of a secular uptrend.

EARNINGS UPDATE
Bottom-up analysts are expecting another good earnings quarter; up 37% in Q1,
following the 200% YoY Q4 results (excluding financials, it was much tamer at
17%).

However, we would say that there are three items that need careful
consideration with regards to the seemingly bullish Q1 profit number.

1. Easy comparisons from last year’s very poor results. Financials are once
again expected to see a large jump of 180% but also Materials and
Consumer Discretionary are penciled in as growing +100% YoY. The other
thing to be mindful of is that oil prices were up nearly 100% as well on a YoY
basis from last year and this explains why the consensus is expecting +40%
for energy earnings.
2. Revenues. Last quarter saw revenues up only 6% despite the massive
increase in profits. This quarter, analysts are more bullish, thinking that
revenues will be up closer to 10%. Unit labour costs in the nonfarm
business sector were down nearly 5% year-over-year and the question going
forward is how much more can firms cut in terms of costs. As Howard
Silverblatt points out over at S&P, if we don’t see sustained revenue growth
going forward, then we won’t see job creation.
3. S&P 500 profits versus NIPA (national accounts) profits. We took a quick
look at consensus estimates for Q1 (the S&P 500 profits) and seasonally-
adjusted them to get a sense where economy-wide profits may be heading.
To reiterate, the consensus is expecting a near 40% increase for Q1, but
once we translate this into seasonally adjusted terms, profits actually
decline on the quarter (sequentially from Q4).

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MY TAKE ON THE U.S. Q4 GDP REPORT

For the second quarter in a row, we saw the final tally for U.S. GDP come in below the
initial estimate. Real GDP was marked down to a 5.6% annual rate in Q4 from 5.9%
in the second revision and from 5.7% in the advance reading. Recall that what was
once a giddy 3.7% annualized pace for Q3 was shaved to 2.2% in the final reading.

The overall contours of the fourth quarter data did not really change that much. Two-
thirds of the headline growth was accounted for by the arithmetic of a lesser
inventory drag and the remainder pretty well coming from net exports and capital
spending. However, these two areas cannot be relied upon based on the latest set
of monthly core shipments and new orders data, alongside what the stronger U.S.
dollar and Europe’s deepening fiscal woes will imply for U.S. corporate sales abroad
(Europe is twice as important as the B.R.I.C.s are, as an aside).

While business spending on equipment and software was revised up as companies

took advantage of the about-to-expire tax breaks, we saw nonresidential
construction, housing and consumer spending all marked lower. Ditto for State &
local government spending, which contracted at a 2.2% annual rate in real terms as
the contraction intensifies.

What was really key was the downward revision to overall real final sales, to a mere
1.7% annual rate from 1.9% in the previous version and 2.2% in the first release of
Q4 GDP. Ultimately, it is final sales that determine the veracity of the economic
expansion and the extent to which a lasting inventory cycle takes hold.

CHART 8: THIS IS A V-SHAPED RECOVERY?

United States: Final Sales of Domestic Product
(year-over-year percent change)
10.0

7.5

5.0

2.5

0.0

-2.5

-5.0
60 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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The 1.7% annualized pace to real final sales in Q4 followed an almost equally tepid
1.5% gain in the third quarter, which makes this the very weakest post-recession
performance (assuming we can call it that) on record outside of the extremely soft
rebound in early 2002. The only difference is that back then, Mr. Market was not
lulled into the belief that the economy had actually turned the corner.

So far in this post-recession recovery, real final sales have only managed to rebound
at a 1.6% annual rate despite all the gobs of government stimulus. To put it into
perspective, real final sales, by now, are usually rising at a 5% annual rate at this
point of other cycles, not sub 2% — and those 5% growth rebounds did not require
nearly as much government support. If we do not see an improvement from this
trend, it would be consistent with profit growth of 5%, which at best would mean $70
for operating EPS for 2010. In other words, the market is possibly trading close to a
17x multiple on forward earnings (forward P/E ratio in the past has averaged 14.7x).

Going forward, the softer tone to demand means that we should not be expecting
inventories to add that much to overall growth. The capex orders and shipments
data are pointing to renewed stagnation in business spending and while commercial
real estate values have picked up from the floor, volumes are still extremely weak.
The accelerating decline in spending at the lower levels of government is offsetting
the stimulus efforts in Washington.

One of the best leading indicators of consumer spending is the ‘expectations’

component of the University of Michigan sentiment index, which just hit a four-month
low and is foreshadowing a halving in the underlying rate of household expenditures
to between 1.0% and 1.5% by the summer. Moreover, the latest data on housing
sales and starts are foreshadowing a renewed leg down in residential construction
after a brief recovery in that past two quarters. And net exports, given the strength in
the dollar and the clouded economic outlook in Europe, not to mention the after-
effects of the credit-tightening moves in India and China, cannot be relied upon to
contribute much, if anything, to headline GDP growth for the remainder of the year.

It’s not so much a ‘double dip’ outlook as one of very weak growth as far as the
outlook for the rest of 2010 is concerned — both fiscal and monetary stimulus
will have faded and the impetus from inventory adjustments will have largely run
its course. The broad monetary aggregates have now either begun to stagnate
or decline outright; the ISM orders-to-inventory ratio has peaked out and leading
indicators, as well as their diffusion components, have rolled over across a
broad front.

So, I would be looking for a second-half growth relapse that sees the
unemployment rate climb back to a new cycle high once the Census hiring effect
subsides and sees the stubbornly high unsold housing inventory drag home prices
down by at least another 10% in a scene that will look highly reminiscent of what
we saw in the back half of 2002. It wasn’t a classic double dip recession like we
saw in the early 80s, but it was a growth relapse that defied V-shaped recovery
hopes at the time and ended up precipitating the unthinkable at the time and sent
both bond yields and equity indices back below their cycle lows.

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March 29, 2010 – LUNCH WITH DAVE

As an aside, the Gross Domestic Income (GDI) results for were also released for
Q4, and it came in better than I thought, at +6.7% annual rate (nominal), which
translates into +6.2% in real terms. That sounds good but Q3 was revised down
— not just down but into negative terrain at -0.02% nominal and -0.4% in real
terms. What this means is that even though based on GDP, the recession
seems to have ended in Q2, on an income basis it only ended in Q3 and that is
only if the Q4 spurt in GDI is sustained.

The split was striking within the GDI report — corporate profits soared at a 40%
annual rate while labour compensation only rose at a 1% annual rate. If you are
looking for a ‘V’, it has indeed been on profit margins or corporate earnings
relative to the economy, which have surged from a low of 7.4% a year ago, to
11.3% currently. Not only is that an unprecedented swing (mostly on cost
cutting) and now matches or exceeds every prior peak, save for the financial-
induced earnings bubble in the last cycle (see Chart 9). This occurred despite
the lack of top-line growth — per unit pricing in the nonfinancial sector deflated
0.2% YoY, but unit labour costs have been cut for three quarters in a row and by
2.7% — something we have not see happen in five decades.

CHART 9: CORPORATE PROFITS RELATIVE TO GDP

United States: Corporate Profits Before Tax to Nominal GDP
(percent)
14

12

10

4
60 65 70 75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Page 14 of 19
March 29, 2010 – LUNCH WITH DAVE

CHART 10: STILL NO PRICING POWER

United States: Price per Unit of Real Nonfinancial Corporate Gross Value Added
(year-over-year percent change)

12.5

10.0

7.5

5.0

2.5

0.0

-2.5
60 65 70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

CHART 11: UNIT LABOUR COSTS HAVE

DRIVEN THE PROFIT IMPROVEMENT
United States: Employee Compensation per Unit of
Real Nonfinancial Corporate Business Gross Value Added
(year-over-year percent change)

16

12

-4
60 65 70 75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

SHOW ME THE MONEY!

Liquidity conditions are beginning to tighten up with the just-released weekly
data from the Fed showing M2 growth slowing precipitously and now negative
on a year-over-year basis in real terms. MZM is already contracting in both
real and nominal terms. Bank credit continues to shrink — by 8.6% YoY and
over 11% on a 13-week rate of change basis.

Page 15 of 19
March 29, 2010 – LUNCH WITH DAVE

CHART 12: M2 GROWTH AT A 15-YEAR LOW

United States: Money Stock: M2
(year-over-year percent change)

15.0

12.5

10.0

7.5

5.0

2.5

0.0
85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

CHART 13: MZM NOW CONTRACTING

United States: Money Stock: MZM
(year-over-year percent change)

40

30

20

10

-10
85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Page 16 of 19
March 29, 2010 – LUNCH WITH DAVE

CHART 14: BANK CREDIT CONTRACTION GAINS DOWNSIDE MOMENTUM

United States: Loans & Leases in Bank Credit for Commercial Banks
(year-over-year percent change)

20

15

10

-5

-10
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

The money supply data is suggesting that the contraction in credit is now
starting to dwarf the Fed’s efforts at bolstering bank reserves — efforts that
will subside after March 31 when the central bank stops buying MBS and lifts
the discount rate another 50 basis points to re-establish the pre-crisis spread
off of Fed funds.

No doubt there were periods in the past when the equity market did just fine
with lackluster money supply growth, but that only happened when economic
and earnings growth really kicked into high gear. Not only is the consensus
currently looking for the YoY EPS growth numbers to soon subside, albeit from
blowout numbers last quarter due to depressed 2008 and early 2009 levels, but
in seasonally adjusted terms the bottom-up consensus is actually looking for
EPS to decline this quarter from the fourth-quarter level. Receding liquidity
coupled with a slower earnings profile promises to shift the investment landscape
towards a more defensive tilt over the near- and intermediate-term, in my view.

Page 17 of 19
March 29, 2010 – LUNCH 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 December 31, 2009, the Firm
managed assets of $5.3 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 December 31, 2009
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 $10.7 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.
$10.7 million2 on
For corporate bonds, we look for issuers
with a margin of safety for the payment
versus $5.5 million for the
of interest and principal, and yields which
S&P/TSX Total Return
are attractive relative to the assessed
Index over the same
credit risks involved.
period.
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-

December 31, 2009 versus $5.5 million for
followed and under-appreciated small
the S&P/TSX Total Return Index over
and mid cap companies both in Canada
the same period.
and the U.S.
$1 million usd invested in our U.S.
Equity Portfolio in 1986 (its inception PORTFOLIO CONSTRUCTION
date) would have grown to $11.7 million In terms of asset mix and portfolio For further information,
usd on December 31, 2009 versus $9.2
2
construction, we offer a unique marriage please contact
million usd for the S&P 500 Total between our bottom-up security-specific
Return Index over the same period. questions@gluskinsheff.com
fundamental analysis and our top-down
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 18 of 19
March 29, 2010 – LUNCH WITH DAVE
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