David A.

Rosenberg January 5, 2010

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

ARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
Market action overseas: IN THIS ISSUE

• Mixed overall in the equity market with Asia up an impressive 1.2%, to a 16- • While you were sleeping —
month high. However, Europe is losing some earlier momentum. mixed action in overseas
equity markets; bonds are
• Bonds are trading slightly defensively just about everywhere. trading defensively;
• Oil continues to rally (now up nine days in a row) on the cold weather snap, commodities rallying;
but gold is hanging in nicely and copper has broken out (though off a tad this economic data were
morning). circumspect
• Commodity currencies are firm with the Aussie dollar and the New Zealand • Interesting revelations
kiwi testing one-month highs. The Yen is firm, the Pound weak and the Euro yesterday — the Dow
consolidating. ended the year down 120
points, and starts the year
The data overnight were circumspect: up 150 points. What
• French consumer sentiment fell in December for the first time in four months. changed in 24 hours?
• While much is being made by the 3,000 drop in German unemployment in • What can equities
December (the fifth straight decline), like many of the U.S. data releases for possibly be discounting?
the month, there were some friendly ‘seasonal adjustment factors’ at play —
the raw data actually showed a 32,000 increase in joblessness and the • The new frugality theme
unemployment rate ticking up to 7.8% from 7.6%. continues on

Good corporate news • ISM index up in December

… but only half of the 18
If there is good corporate news out there, it is in the behaviour of bonds as credit industries reported growth
spreads have collapsed in the past month (to nearly 250bps for 10-year Baa on the month
product from around 300bps). The S&P speculative default rate fell last month • Auto sales are now
for the first time since the crisis intensified in October 2007. And, we see that coming in around 11
the distress ratio — the share of high-yield corporate debt trading in excess of million units (annualized)
1,000bps over Treasuries — has collapsed to 15% from 70% just a short nine — this is the new normal
months ago. We have been constructive on spread product but one would have • U.S. small businesses still
to believe that the easy money has been made and that a disciplined focus on in a credit quagmire
quality, duration and liquidity (cash on hand) as well as sector specifics (less
• No housing recovery in
cyclical the better) is recommended at this time.
the U.S.
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 Krugman, Feldstein and
as inventory restocking and fiscal/monetary stimulus both begin to fade. We Roach see 30-40% odds
see that Steve Roach, in a piece he published for Bloomberg News, is also of another recession
calling for 30% odds of a double dip in the global economy this year. unfolding

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 Nearly 20% of U.S.
government stimulus, directly and indirectly. The same stock market that
personal income is now
coming from Uncle
couldn’t see a recession coming in late 2007 even though it was two months
Sam’s generosity
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

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 Barron’s 2010 outlook
to these counties ($130 billion) account for less than 1% of U.S. GDP. So where had “groupthink” written
exactly is the arithmetic here that will support the economy if and when the Fed, all over it
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 The consensus sees $76
percentage points of corporate earnings growth. The consensus sees $76 of operating EPS for the
operating EPS for the S&P 500 next year, which compares to a likely $56 stream S&P 500 in 2010, which
in 2009. In other words, that would imply an expected 36% profits boost this would be a 36% increase
year. That in turn would require a 14% increase in nominal GDP, which is from 2009
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.

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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 The S&P 500 rallied 23%
500, from point to point, rallied 23% in 2009 even though earnings for the year in 2009 even though
as whole came in a whopping $22 a share or 27% below what was being priced earnings for the year
in at the start of the year. Now that is remarkable. It almost wants to make you came in a whopping $22
believe in the tooth fairy. a share, or 27% below
what was being priced in
We are sure that if we told you on December 31, 2008, that the market was at the start of the year
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.

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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, The ISM index beat
like the ISM, but this is all noise around a fundamental trend that is still heading consensus views,
south. Yesterday’s Chicago Tribune ran with an absolutely chilling article titled coming in at 55.9 in
Recession Could Permanently Scar The Thinking of Americans 18-25. Here are December from 53.6 in
some excerpts … but as Tevya warned Golda after the his staged nightmare,
November (market was
bracing for 54.3). This is
“don’t be frightened!”:
a new recovery high,
breaking above the 55.7
“After living through one of the most brutal recessions in U.S. history,
mark set in October
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.

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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 With all the commotion
12 the month before (67%). As with some of the other data we have seen for about the ISM, what was
December, there seems to be some strong seasonal adjustment factors skewing masked in yesterday’s
the data (ie, the current factors may be overcompensating in taking into account data release was
the dramatic post-Lehman weakness a year ago and adjusting for it). construction spending,
which came in below
But what got lost in the commotion was the November construction data that expected in November
was released at the same time … unlike ISM, the monthly construction numbers
and underwent a big
downgrade in the
feed right into GDP and we would look for some trimming around the Q4
October figures
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.

Page 6 of 9
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

Page 7 of 9
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 INVESTMENT STRATEGY & TEAM

As of September 30, 2009, the Firm
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Gluskin Sheff became a publicly traded
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Our investment interests are directly
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We offer a diverse platform of investment
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Alternative and Fixed Income) and
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1 September 30, 2009
Income).
The minimum investment required to
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Firm is $3 million for Canadian investors
and $5 million for U.S. & International
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PERFORMANCE
$1 million invested in our Canadian Value which we have the highest conviction.
Portfolio in 1991 (its inception date)
would have grown to $15.5 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
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levels. Our performance results are those
Sheff’s management and
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employees are
We have a strong history of insightful collectively the largest
bottom-up security selection based on client of the Firm’s
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investment portfolios.
For long equities, we look for companies
with a history of long-term growth and
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$1 million invested in our
Canadian Value Portfolio
share price below our estimate of intrinsic
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date) would have grown to
equities that we sell short.
$15.5 million2 on
For corporate bonds, we look for issuers
with a margin of safety for the payment
versus $9.7 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
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way, clients benefit from the ideas in
Our success has often been linked to our

long history of investing in under-

September 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
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and the U.S.
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usd on September 30, 2009 versus $8.7
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million usd for the S&P 500 Total between our bottom-up security-specific
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fundamental analysis and our top-down
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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 8 of 9
January 5, 2010 – BREAKFAST WITH DAVE
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