David A.

Rosenberg August 19, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
Asian equities were higher today but the action in Europe is broadly mixed. The
Nikkei bounced 1.3% to 9,362 and JGBs sold off on mounting speculation that the • While you were sleeping:
Asian equities were
Bank of Japan is going to reverse the yen’s strength and thereby stimulate export
broadly higher today but
growth. It seems these days that nobody wants a strong currency, hence the the action in Europe is
sustained uptrend in gold — the yellow metal is riding a five-day winning streak. broadly mixed; government
bond markets are selling
Government bond markets are selling off in this morning. The news is all good off this morning
with the Bundesbank raising its 2010 growth forecast for Germany, to 3% from • The bond bubble debate
1.9%, but frankly, this was just a ‘mark-to-market’ exercise after those blowout Q2 revisited: “One Rosie”
GDP numbers last week. Corporate bond risks are fading in Europe as per the takes on “Two Jeremies”
improvement in the CDS market and we are seeing 3-month euro LIBOR/OIS
• Frugality gaining more
spreads come in sharply today — helping today was the EU stating that Greece’s acceptance
efforts to rein in its budget deficit are surpassing expectations, as a result, the
country is on track to receive more EU financing. • Investor sentiment swings
• The polls don’t lie: the
The U.K. also printed some solid industrial data, as per the CBI survey for August — latest polls showed that
across-the-board improvement in exports, output, orders and pricing. And, oil and only 41% of the public
copper are both firming alongside the better tone to the European data as well as approve of President
Obama’s handling of the
the positive tone to the Chinese stock market, which is a decent leading indicator
economy, down from 44%
for the commodity group. in April

What doesn’t square with all this pro-risk trading is the strength in the USD at the • Bond yields must go down
current moment — usually risk trades are being pulled off the table and the U.S. more
dollar is bid so far today. • Credit strains linger: bank-
wide loan delinquency
Another piece of news that does not totally fit the bullish bill is the move in the 30- rates actually rose in Q2,
year German bund yield to below the 3% mark (2.96%). Deflation odds would still to a new high of 7.32%
from 7.26% in Q1 and
seem to be nontrivial based on that move alone. As for the major U.S. averages,
6.44% a year ago
yesterday’s tenuous up-move took them to their 50-day moving averages but
resistance may be setting in and the missing link in many of these positive-action-
sessions is still the lack of volume. In other words, conviction levels are low
regarding the sustainability of any rally.

If there is good news out there it is that the hard work from Mr. Bond (see more
below) has taken key borrowing costs for households down to levels that have
touched off a decent increase in mortgage refinancings — up 17% last week and
at their highest levels since the ‘green shoot’ days of May 2009 — every penny in
consumer pocketbooks counts in these frugal times. Morgan Stanley estimates
that there is potential for $46 billion of cash-flow for the U.S. consumer that
would be the equivalent of a 0.5% pay increase; modest perhaps but better than
a kick in the pants.

Please see important disclosures at the end of this document.

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August 19, 2010 – BREAKFAST WITH DAVE

And while deflation is still not part of anyone’s base-case scenario — save for us,
Gary Shilling, Doug Behnfield, Robert Spector, Albert Edwards, Lacy Hunt and If you are looking for where
Van Hoisington (we need one more for two tables of bridge) — the risks are rising the next proverbial shoe is
nonetheless. For a real-world example, look no further than page B8 of today’s going to drop, look no further
NYT, Pizza Hut Cuts Prices again to Counteract the Slow Recovery. A large pizza than public sector pension
is now going to sell for ten bucks and we have pundits out there talking about funds
hyperinflation — stop eating at the French Laundry!

Also, have a look at what P&G is up to on the front page of today’s WSJ as it
moves to recapture share of the global market for consumer goods —
“Consumers might be willing to shell out for iPads, but their day-to-day
spending reflects an entrenched frugality that often means leaving P&G’s
relatively inexpensive products on the shelf. Nearly two-thirds of U.S.
consumers said they switched to a cheaper substitute for at least one basic
household product, food or beverage, in the past year …” This probably
includes saki and sashimi because this was definitely the pattern that
emerged in post-bubble Japan (oh, but we’re different … right).

Meanwhile, if you are looking for where the next proverbial shoe is going to drop,
look no further than public sector pension funds and how their actuarial
liabilities estimated between $1 and $3 trillion are going to have to be
addressed — and it is not going to be through a federal bailout and the PBGC
only covers private plans. Big reforms and shared sacrifice are coming soon —
have a look at the op-ed article on this topic on page A17 of the WSJ.

THE BOND BUBBLE DEBATE REVISITED:

“ONE ROSIE” TAKES ON “TWO JEREMIES”
I was desperately trying to resist the temptation to retort to yesterday’s op-ed piece
I was desperately trying to
on page B13 of the WSJ (The Great American Bond Bubble by Jeremy Siegel and
resist the temptation to
Jeremy Schwartz). But alas, I have succumbed, for the following reasons: retort to yesterday’s op-ed
piece on page B13 of the
1. I was inundated with emails from our readership to respond. I finally said,
“enough is enough.” WSJ (The Great American
Bond Bubble) … alas, I have
2. Since I already took on the “Two Jimmies” (Grant and Caron) in the spring on succumbed
their 5½% forecasts on the 10-year Treasury note yield, I thought, in the
name of acting in a consistent manner, that it would only be fair to refute the
arguments made by the “Two Jeremies.”
3. Almost three months ago, I submitted an op-ed piece to the WSJ for its
consideration titled “Bond Bubble” but my request was turned down. Not
that this is a case of sour grapes because the FT went ahead and published it.
But, the fact that the WSJ turned my piece down while printing the diatribe by
Messrs. Siegel and Schwartz goes to show that for whatever reason, there
seems to be this bias on Wall Street against the bond market (the “enemy”).

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4. Finally, after such a tortuous read, I simply felt that the assertions made in The move to fixed-income
yesterday’s WSJ op-ed piece could not go unchallenged. Everybody is
entitled to their opinion but if I had to make the case that bonds were a poor
assets may indicate that Ma
investment — and someday I will, believe me — I surely would not lean on the and Pa Kettle are adjusting
spurious reasoning provided in yesterday’s column. The case against the their balance sheet to
bond market that was made was pretty weak, which goes to show that just capture more income, limit
because you have the pedigree of being a professor from Wharton doesn’t their risks and preserve their
necessarily mean your call on the Treasury market will prove to be any more capital
prescient than your call on “Stocks for the Long Run.”
Here’s why.

The “Two Jeremies” stated that “from January 2008 through June 2010,
outflows from equity funds totalled $233 billion while bond funds have seen a
massive $559 billion of inflows.” They describe this as a “rush into bonds.”

The question is: so what? If anything, this shows that the retail client has
developed some real financial acumen considering that Treasury bonds have
generated a total return of 13% over that timeframe versus -21% for equities. In
fact, both the absolute and risk adjusted return on Treasury bonds have been
spectacularly superior to equities for the last 10 years. To be sure, past trends
cannot be relied on for future performance, but what is not mentioned in the
WSJ piece is that households may be deliberately rebalancing their asset
allocation because 27% is represented by equities, another 27% in real estate,
but a mere 6% is in fixed-income securities.

So maybe Ma and Pa Kettle are moving to correct this mismatch on their

balance sheet and adjusting it to capture more income, limit their risks and
preserve their capital. We do know with certainty that the median age of the The “Two Jeremies” compare
baby boom cohort is approaching 55. As strategists we have to come to the this apparent “bond bubble”
understanding that a powerful demographic trend is gathering momentum, to the “technology mania” a
which is generating this insatiable appetite for yield — an era of correcting the decade ago
underweight in bonds in the aging (but not aged) boomer asset mix while
correcting the lingering overweight in equities. This may prove to be a secular
shift and it just makes sense to come to grips with what is likely to be a
continued divergence in bond and stock performance in the future.

The “Two Jeremies” compare this apparent “bond bubble” to the “technology
mania” a decade ago. Some bizarre comparisons, using an estimate of a P/E
multiple on the Treasury market of 100x, were cited but were far too opaque for
me to fathom. At the same time, it is a legitimate question as to how to quantify
whether bonds are overvalued or undervalued at any given point in time. What
is more important to identify, at least in my opinion, is what the critical forces
are that drive yields up or down. It’s nice to compare what we are seeing in
bonds today to what the dotcoms did a decade ago but it’s hardly relevant
because the variables that influence speculative stocks are completely different
than those that affect the direction of long-term interest rates. Alan Greenspan
thought that growth stocks were “irrationally exuberant” six years before the bull
market ended.

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What finally did end it was not any particular valuation metric but perhaps Cisco
missing by a penny on the other side of consensus expectations, leading to a But really, let’s fade
dramatic reassessment of the earnings landscape. If there is one thing we do valuation comparisons
know, equity prices will track earnings-revision-ratios very closely. Then of between bonds and growth
course, we had a capital spending-induced recession that practically nobody saw stocks. It’s such a silly
coming in 2001, and we’ve never had a recession without cyclically-sensitive argument
equities enduring a severe bear market.

So let’s fade valuation comparisons between bonds and growth stocks. It’s such
a silly argument. Nortel did go bankrupt, as did a slate of tech stocks. Your
capital wasn’t preserved — it was extinguished. Nortel was the darling of the
day, at one point representing more than 30% of the Canadian stock market
capitalization. Equities, by their nature, are riskier than Treasury bonds — some
more than others. Obviously, the Bill Millers, Warren Buffetts and Ira Gluskins of
this world have in their professional lives managed to find some real gems that
generated significant returns for their unit holders. But at no time was your
capital guaranteed. So how can anyone compare that to a government
obligation with an ironclad guarantee of interest and principal payments? Do we
use a tech stock as the risk-free benchmark for funding actuarial liabilities? Or
is it the long Treasury Strip? Does a tech stock, or any piece of equity paper, tell
you with full certainty what you are going to be paid upon maturity? Or is that
the long Treasury Strip? Why even bother comparing these two investment
vehicles, they serve completely different purposes and are purchased by two
very different mandates.

Furthermore, I feel strongly that this notion that the U.S. government, with all its
taxing power and vast holdings of the national assets and treasures (dare we I feel strongly that this
say, including what lies beneath Fort Knox) is going to default someday is notion that the U.S.
completely ludicrous. All we seem to talk about is the gross debt burden. This is government, with all its
not to downplay the fiscal situation, which is dire, but becoming hysterical could taxing power and vast
lead to poor judgment and decision-making. holdings of the national
assets and treasures is
Canada faced similar structural deficits in the early 1990s, had its credit rating going to default someday is
downgraded several times, and there were hues and cries back then as well completely ludicrous
over Canada’s ability to service its debts. However, years of shared sacrifice
cured those ills and there were no defaults, late payments, haircuts or even a
move to inflate the liabilities away. So give me a giant break on U.S. sovereign
credit risks. Talk of default is complete and utter nonsense — and frankly, it’s
obnoxious. More likely, America is going to go on a multi-year path towards
fiscal probity, which will involve more taxation, sharply lower spending on non-
essential services, and shared sacrifice, as was the case in the 30s and north of
the border in the 90s.

So let’s go back to first principles. It matters little what level Treasury yields are
sitting at. You could be sitting there with a 10% coupon but if yields, for
whatever reason, were to jump to 20% and stay there, you would likely suffer a
huge loss if you had to sell before maturity. So the fact that yields are at 10% or
3% matters little in this debate.

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To reiterate, it was the macro economic landscape, not the valuation backdrop,
that proved to be the undoing for tech stocks in the opening months of 2000. It We are rapidly running out of
is far more relevant and useful to discuss what the triggers would possibly be to disinflation and we are
drive yields higher and on a sustained basis. staring deflation in the face

I did the research on this long ago. Budget deficits (and surpluses) have a 40%
correlation to bond yields. Just as a deficit of $1.5 trillion did not prevent bonds
from staging an impressive rally this year, surpluses in 1999 did not stop the
Treasury market from enduring its second worst year in recorded history, in total
return terms. You see, in 1999, we had the Fed tightening policy and inflation
pressures percolating. In 2010, we had the Fed reiterating its commitment to
keep policy rates to the floor. At the end of last year, the consensus was
convinced the Fed would be hiking rates by now ... the fact that the central bank
hasn’t done that, let alone start to shrink its pregnant balance sheet, has to be
one of the biggest surprises so far this year.

We are rapidly running out of disinflation and we are staring deflation in the face
— the year-on-year trend in the core CPI (which excludes food and energy) is just
88 basis points away from breaking below the zero-line. Our research show that
Fed policy has a near 90% correlation with the direction of bond yields — you just
don’t go into a sustainable bear markets when the Fed is not taking the “carry”
away. Moreover, inflation as measured by the year-over-year change in the CPI,
for all its blemishes and imperfections, commands a near 80% correlation with
the Treasury market.

Yet in this whole discussion of the bond market, nowhere do the “Two Jeremies”
talk about their forecasts on the Fed and on inflation. These are the two most
vital components of interest rate determination and they are not even discussed
in this “bond bubble” piece.

Look, instead of debating bubbles maybe it is more appropriate to identify where

bond yields could go before they ultimately bottom. This would seem to be more
relevant for investors than lamenting how low they already are — as if that would
have helped anybody figure the JGB market out over the past decade (and with
a Japanese government debt-to-GDP ratio of 200%!). Well, the Fed just told us
that it has no intention of hiking rates for a long, long time. So, Fed tightening
risks are off the table and at a time when the policy rate is almost zero. And we
have a long bond yield of 3.6%. That is a 360 basis point curve from overnight
to 30 years, and historically, that spread averages out to be 200bps.

As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we

should see the long bond yield approach or even possibly test the 2% threshold
before its final resting stop is reached. If we are right on -1% to -2% deflation in
coming years as the post-bubble excesses continue to unwind, nominal yield will
actually be quite juicy in “real” terms.

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Interestingly, when Ben Bernanke gave his “What If” speech in November 2002,
he mentioned that in a 0% funds rate world where deflation risks intensify, he As we invoke Bob Farrell’s
would begin to target long-term rates — and cited how in the decade to 1951, Rule 1, which is about
the Fed established an explicit ceiling on the long bond yield at 2.5%. reversion to the mean, we
should see the long bond
The “Two Jeremies” go on to then bash “the purveyors of pessimism” and in a yield approach or even
manner we can only describe as convoluted. Admittedly, I couldn’t comprehend possibly test the 2%
their thought process. They are of the view that no matter what, “U.S. economic threshold before its final
growth is likely to accelerate.” No mention is made of the fact that the mini-
resting stop is reached
inventory cycle has run its course and that we are past the peak of the
monetary, fiscal and bailout stimulus. The economy slowed to stall-speed in the
second quarter and is on the precipice of contracting in the current quarter.
What do the “Two Jeremies” see that the Fed didn’t see when it cut its macro
forecast last week for the second time in the past six weeks? What is the
exogenous positive shock to the economy that turns the tide back to one of
positive momentum?

At least in 2003 the Fed could cut rates and Bush could dramatically cut taxes. On
top of that, we had the proliferation of subprime mortgages, interest-only
mortgages, no-doc loans, low-doc loans, liar loans as well as the feel-good effect of
a 20% annual home price appreciation. The securitized loan market that blazed
the trail for that wonderful leveraged “ownership society” bull market and
economic expansion from 2003 to 2007 is 60% the size today of what it was three
short years ago. Do the “Two Jeremies” realize that a huge chunk of the credit
market that financed the false prosperity of the last great bull run in risk assets
and the economy is no longer around? Nowhere in the article is there a convincing
case for above-trend growth, which will be needed at some point to chip away at
the widespread excess capacity and touch off the inflation and Fed tightening
cycle that would truly make the bearish case for bonds a compelling one.

There was emphasis in the article on dividend yield and dividend growth and
indeed, this is part of our own Safety and Income at a Reasonable Price strategy
(S.I.R.P.). This is an era of income orientation, and to be sure there are many
areas of the market in which an income stream can be derived — REITs, trusts,
corporates, muni’s, oil and gas royalties, preferreds, and reliable dividend
growth. Agreed.

But the “Two Jeremies” use this as an argument against the Treasury market.
We don’t get it. Okay, there’s an average 4% dividend yield in the blue-chip
stocks they cited. That's fine. But why not complement the bonds in your
portfolio with these income-oriented equity investments? Why do the “Two
Jeremies” make it sound like it’s one or the other? Why can’t they co-exist
within the S.I.R.P. thematic? The fact that AT&T has a decent dividend yield is
the reason there’s a perceived bond bubble? How does that make any sense?

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As an aside, there was no mention of where the bonds trade for these blue-
chip companies — we only read in the article about the dividend yield and the
earnings yield. Nothing on their bonds, which are probably also alluring with
the added bonus that you line up in a better part of their capital structure.
Keep in mind that no matter how “safe” an equity investment is, it is all
relative — your capital is not guaranteed. No equity is totally safe. Even in the
corporate bond space — mortgages too — investors face call risk and that can
certainly be a nuisance. In a period when interest rates are falling and
corporate and household debtors move into refinancing/prepayment mode
even non-Treasury debt has its risks. Nowhere in the WSJ op-ed piece is there
a word mentioned about the unique non-callable nature of government bonds,
and that investors may well be putting an increasing “price premium” on
Treasuries in light of this feature that is practically non-existent in other
segments of the fixed-income universe.

This really appears to be a case of one’s assumptions driving one’s conclusions (or
maybe in this particular case, the conclusions drove the assumptions). The “Two
Jeremies” cite stellar productivity growth (“almost twice the long-term average”) as
a reason for their bullish view on the economic landscape. But there is no mention
of what role this productivity is playing in keeping the unemployment rate so
elevated and as a result dampening wage pressures. Why?

Moreover, there was no mention as to the huge role this productivity has played
in depressing unit labour costs, which, in fact, is deflating at a record pace.
These guys are bullish on productivity and yet bearish on bonds, even though
the productivity they cherish is one big reason why inflation is melting and bond
yields are rallying to the levels they are at today! Think about the logic in that.

The comment that households are “pouring money into bond funds” also
ignores the fact that much of this inflow was not directed into Treasury bonds
(see Investors Buy Consumer Debt on page C14 of yesterday’s WSJ — not
everything the retail client did this cycle necessarily dovetailed with our S.I.R.P.
theme). In fact, over the past two years, less than $60 billion or only 12% of the
net inflows to bond mutual funds were devoted to Treasuries — these “retail
investors” ploughed in nearly twice as much into corporates. This fact was not
mentioned in that op-ed piece.

Moreover, the implicit assumption here is that “retail investors” (the general
investing public) don’t know what they are doing — they always do the wrong
thing at the wrong time. It is a comforting refrain, but keep in mind that retail
investors were actually shedding their equity exposure at a faster rate than
institutional investors were raising cash levels going into the financial crisis. You
just can’t look at the “flows” without also looking at the “stock” and as we
stressed above, what we are likely witnessing is a deliberate asset mix shift.

Then there is the one-sided comment that if the 10-year note yield were to rise
back to 3.15% in the next year, total returns would be nil. Fair enough, “if” that
were to happen.

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Now interest rates will of course fluctuate, but if the intermittent spasms occur
alongside a primary trendline that is down (in yields) then there should hardly be
concern about these periodic setbacks. If we are correct that we are still in the
throes of a secular bull market in bonds, even if in the mature stage, then
moves to 3% or above, should they occur, will prove to be great buying
opportunities, not unlike the repeated tests of 4% that saw over the past year
(and as early last April).

If the conditions for a continuation of the bull market in bonds is intact, then
think of what the potential returns would be if the long bond yield were to grind
down towards 2.0% or 2.5%. The “Two Jeremies” failed to mention that such a
move would generate total returns of around 30% for long coupon bonds and
65% on the long strip! Ah, the power of convexity at low levels of interest rates —
every basis point move magnifies the total return. The same bearish arguments
about the bond market being “overvalued” could have been made at the start of
the year, and to be sure, they were made in various circles, which is why the
broad consensus was for equities to outperform Treasuries again this year.
Meanwhile, even in the face of low yields, the price appreciation has been so
powerful that the long-dated Treasury Strip (30-year) has generated a net
positive return of nearly 30% so far this year versus -2% for the S&P 500. It may
be a mistake to argue with success.

In sum, there is no bond bubble. The latest Commitment of Traders (CoT) report
show there to still be a small net short position among non-commercial accounts,
as far as the long bond is concerned, and basically flat for the 10-year T-note. The
long-standing net short position has been closed but one can hardly look at this
data and conclude that there is rampant bullishness among speculators.

So, while there may be a technically overbought technical condition and while
bullish sentiment readings are very high, indeed according to some recent
surveys, we are still a long way from capitulation (epiphany?) by Wall Street
economists and strategists. One critical element missing is the speculative
fervour, which hit the dotcoms in 2000 and real estate by 2006. Be assured
that you know the lows in yield have been turned in when the CoT report shows
there to be massive amounts of “net speculative longs.”

Fundamentally, what we have on our hands is a powerful demographic appetite

for yield at a time when income is under-represented on boomer balance sheets.
At the same time, while fiscal deficits are very high, they are unlikely to expand
any further given the recent political backlash against more expansion of the
government debt-to-GDP ratio. All the while, the two most significant
determinants of the trend in long-term bond yields — Fed policy and inflation —
continue to flash “green”, and at a time when the yield curve is still historically
steep and destined to flatten. With the process led by ever-lower long-term rates
since the central bank has already assured us that short-term rates will remain
at rock-bottom levels for as long as the eye can see.

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FRUGALITY GAINING MORE ACCEPTANCE

Page B1 of yesterday’s WSJ ran with Retailers Are Sold on Frugality —and the
opening line went like this:

“American retailers are becoming as frugal as their shoppers, cutting expenses

to maintain stable profits through what is increasingly looking like another
challenging holiday season.”

I can’t help but smirk a little bit because it was two years ago that I invoked this
as part of my deflation theme and hopefully some will recall my old chart
package dubbed “The Frugal Future”. To be honest, when I marketed that view
in my last 18 months at Merrill Lynch, people thought I had really lost my
marbles. Back then, it was universally believed that one should never ever
count out the never-say-die, shop-till-you-drop American consumer. Indeed, old
habits die hard but at some stage, denial will turn to acceptance. Who in the
economics community was calling for a 6½% personal savings rate by now?
And it’s not over.

While Wal-Mart managed to beat its EPS targets, its U.S. same-store sales
numbers have been negative on a YoY basis for five quarters in a row. Retailers
are only managing to scrape by via reductions in employee hours, maintaining
very tight inventory controls, gaining concessions from suppliers — in other
words, aggressive cost-cutting.

Here is what Wal-Mart CEO Mike Duke had to say about the consumer spending
environment:

“The slow economic recovery will continue to affect our customers, and we
expect they will remain cautious about spending.”

Home Depot CEO Carol Tome had this to say — the firm just sliced its full-year
sales growth forecast to 2.6% from 3.5% (even as it raised its EPS guidance).

“How in the heck can you increase earnings with tighter revenues? The answer
is that we expect some expense relief.’

And the CEO for Urban Outfitters, Glen Senk, said this:

“I am not bullish about the second half. We're facing a slow and lengthy
recovery that will be punctuated by periods of uncertainty.”

Target’s CEO Gregg Steinhafel added this:

“It’s clear that the second quarter marked a change in recent trend. Following
stronger results in the last two quarters, gross domestic product growth
softened considerably and our sales trends leveled off as well.”

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Target managed to post a 14% YoY profit gain but this largely reflected the
benefits of luring its debit/credit-card holders into its stores with 5% discounts (no
deflation, eh?) as well as a general improvement in delinquency rates (debtors
today only stop paying their mortgages — the credit card has ostensibly become a
consumer staple). In any event, Q3 sales expectations right now is a mere 1%.

On Monday, Lowe’s also managed to raise its 2010 profit forecast but at the
same time lowering its annual revenue projections. Abercrombie & Fitch is
another case in point — sales are up even with average prices for its
merchandise down 15%. Call it deflationary growth.

However, for some retailers it is just deflationary — even for discounters like TJX,
which is forecasting second-half sales to be flat to down. And, companies like
Wal-Mart are reporting that they are detecting the return of the paycheck cycle.
In fact, the NYT reported (page B3 of yesterday’s paper) that “steeper price-
slashing did not lure customers into spending more at Wal-Mart, while shoppers
at Home Depot spent less and put off big home improvement projects of big-
ticket items like appliances.”

That last comment had a certain Japanese feel to it and is a reason why Ben
Bernanke is so concerned about deflation — the distorting impact it can have on
economic behaviour. In inflationary times, like the 1970s and early 1980s,
when everyone begins to expect more inflation, households and businesses tend
to buy more now and stockpile to get ahead of the next round of price increases.
But the very action to buy more now boosts demand and fuels the very
inflationary pressure that “economic agents” are attempting to bypass. So
inflation becomes deeply embedded in expectations and leads to tremendous
distortions and resource misallocation.

The same is true but in reverse in deflationary times — as we are seeing take
place at Wal-Mart. In this condition, people put off their spending plans in the
hope of getting a better bargain down the road. This reduces demand, leaves
unwanted inventory on the shelves in the retail sector, and this in turn reinforces
the downtrend in pricing.

Finally, part and parcel of our frugality theme two-years ago was the need — the
desire, in fact — to get small: smaller homes, smaller cars, smaller credit lines,
smaller workforces, smaller budgets for discretionary goods and services. This
is why the article on how commercial tenants are finding ways to economize on
“space” in yesterday’s WSJ was so fascinating (Office-Leasing Rebound Could
Be Deceiving on page C6). Just another example of the ‘new normal’.

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SENTIMENT SWINGS
Equity and market sentiment is swinging wildly week to week, but in the most
recent Investors Intelligence Poll, there is at least a sparkle of capitulation
(though we likely need to see a lot more). The bulls lost ground, to 36.7% from
41.7% last week, and the bear camp expanded, to 31.1% from 27.5%. We
suppose it says something that the landscape is still populated with more bulls
than bears, but it is only fair to point out that the bull/bear spread shrank a
considerable 8.6 points this week.

We have also been hearing that bullish sentiment towards Treasuries is now 98%,
according to some surveys, approaching the incredible 99% on December 16,
2008, right as yields were plunging to their trough (the 10-year note approaching
2%). It was at that time that I wrote a report (while still at Merrill) titled “Saying
Goodbye to an Old Friend” in which I had suggested that Treasuries were
overbought and that there were better opportunities in the fixed-income market (in
mortgages, corporates and even muni’s). I never turned outright bearish on T-
notes and bonds but thought we could be in for a correction, which we endured for
about a year and almost 200 basis points on the 10-year. The rally in late 2008
also took place right after the Fed made an announcement to buy bonds, and to
some extent we have seen a déjà vu in the past week. Although, back then the
bond market did a lot of the rally off the April high in yields all on its own — without
any help from Ben Bernanke or China for that matter.

But there are some differences. The bounce in yields off the December lows
occurred as depression talk was rampant, not to mention the implosion of the
banking system. All it took was for the government to safeguard the financials and
come up with a massive fiscal stimulus program to prompt a major short-covering
rebound in the stock market and a shift out of the safe haven provided by the
Treasury market. Back then, all we had to do was take GDP growth from negative
terrain to flat and “green shoots” would sprout across the economic garden. So,
we had the stimulus to look forward to, we had the peak in growth still ahead of
us, and a new activist government that had everyone excited over a new path,
both politically and economically. We had the shorts running for cover.

So, it may well be the case that bond market sentiment has swung to extreme
levels. At the Grant’s Conference in April, Jim labelled the event we closed down
together on stage as “Bonds are for losers.” Even in June, the Barron’s poll
showed the vast majority of forecasters calling for higher yield activity. Now
every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old
shop who are now broadly filled with perma-bulls (now are calling for a 2.5%
yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel.

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So yes, we could well see a near-term reversal in this impressive bond rally. But
no, it won’t be nearly as severe as it was in 2009 and there is still a very strong
likelihood that yields out the Treasury curve do what the front end has already
done and move down to new lows. The peak in growth is behind us, not ahead
of us anymore. There is nothing to be excited about politically, unless you think
the GoP winning the House and the Senate in November by default and with no
articulated vision of its own is a reason to be bullish. When leadership is
wanting, sorry, gridlock is not good. Not at all.

And, there are no more fiscal rabbits to be pulled out of the hat — the majority of
Americans are saying enough is enough on this experiment in testing the outer
limits of our deficit financing capabilities as government debt relative to GDP
approaches a game-changing 100% ratio. Remember, back in early 2009, all it
took was a move to zero percent growth — just stop the economy from falling off
a cliff! — to prompt a multi-month bond selloff and an equity rally. That says
something about “expectations” back then.

Fast forward to today, and imagine if yet again we move to zero percent growth
— we doubt we will get the same investor reaction this time around, especially
with the market primed for over 20% earnings growth over the course of the next
4-6 quarters.

THE POLLS DON'T LIE

There are 11 weeks to go before the November 2nd mid-election in the U.S. and
based on the just-released Associate Press poll, one would never have thought
that 1) the Fed had cut the funds rate to zero, 2) tripled the size of the balance
sheet all in the name of regenerating a credit cycle, 3) the federal government
would have initiated at least eight different housing programs to underpin the
real estate sector, and 4) would have embarked on a historic fiscal stimulus
plan. The latest poll showed that only 41% of the general public approve of
President Obama’s handling of the economy, down from 44% in April. Fully 56%
disapprove. And get this, 61% think the economy has worsened since he took
office. How is that possible?

In June, 72% believed the economy was “poor or very poor” and just two months
later than share has risen to 81%. In June, 19% said the economy was
“improving”; that number is now down to 12%.

BOND YIELDS MUST GO DOWN MORE

We don’t understand it. The equity bulls hate the Treasury market and seem as
though they are fanatic in their calls for higher rates. Yet if you are bullish in
equities, wouldn’t it make more sense to want the cost of credit to go down to
stimulate economic growth (and last we say, the earnings that equity investors
pay for are part of the economy)? The bond market is now the only game in
town — with policy rates at 0% and tapped out on the fiscal front. It’s all up to
the bond market — long-term interest rates — and at least Ben Bernanke
understands this even if most portfolio managers and market commentators do
not.

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August 19, 2010 – BREAKFAST WITH DAVE

The bond market has worked hard — without the rally in Treasuries, mortgage
rates would not have tumbled 60 basis points in the past year. The problem in a
credit contraction is that it is difficult to revive demand unless interest rates
decline to microscopic levels. But, as we saw in Japan, even then there is no
certainty that spending will turn around.

What we know is that mortgage applications for new home purchases — these are
not approvals but rather a true proxy for home purchases, slid 3.4% last week
even in the face of the huge bond rally and they are now down 38% from
depressed year-ago levels. Again, this is a sign, to us at least, that the bond
market is going to have to work that much harder. This in turn means that long-
term rates will head even lower, and not until they do the job in generating
sustainable growth will this bull phase in the Treasury market fully run its course.

CREDIT STRAINS LINGER

Here we were led to believe by all the analysts that we had somehow moved to a
new and better inflection point as it pertained to U.S. credit quality, but that
doesn’t seem to be the case. At least not if the reported Q2 data out of the Fed is
accurate.

Bank-wide loan delinquency rates actually rose to a new high of 7.32% in Q2 from
7.26% in Q1 and 6.44% a year ago. While there were improvements in credit
cards and C&I loans, there was significant deterioration in the real estate sector —
the delinquency rate for residential mortgages climbed to 10.05% from 9.74% in
Q1 and 8.21% a year ago; and commercial real estate loan delinquency rates
edged up to 8.79% from 8.65% in Q1 and 7.85% in 2009 Q2.

Yesterday’s NYT ran with a nifty little article that came up with solutions for the
future in terms of reining in credit bubbles before they start (see Rein in
Borrowers to Fix Mortgages). For example, repealing the ‘sacred cow’ that
allows mortgage interest deductibility (this “goodie” costs Uncle Sam about
$100 billion every year); giving banks full recourse (as we have in Canada); more
aggressive down-payment requirements; limits on mortgage refinancing; and
more stringent underwriting criteria.

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August 19, 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 June 30, 2010, the Firm managed
assets of $5.5 billion.
1
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
2 31, 2010 versus $5.7
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 $11.7 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.
$11.7 million2 on March
For corporate bonds, we look for issuers
with a margin of safety for the payment
million for the S&P/TSX
of interest and principal, and yields which
Total Return Index over
are attractive relative to the assessed
the same period.
credit risks involved.
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-followed

March 31, 2010 versus $5.7 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. PORTFOLIO CONSTRUCTION
Equity Portfolio in 1986 (its inception In terms of asset mix and portfolio For further information,
date) would have grown to $8.7 million construction, we offer a unique marriage please contact
usd on March 31, 2010 versus $6.9
3
between our bottom-up security-specific questions@gluskinsheff.com
million usd for the S&P 500 Total fundamental analysis and our top-down
Return Index over the same period.
macroeconomic view.
Notes:
Unless otherwise noted, all values are in Canadian dollars.
1. Preliminary unaudited estimate.
2. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.
3. 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 14 of 15
August 19, 2010 – BREAKFAST WITH DAVE
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