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David A.

Rosenberg May 21, 2010

Chief Economist & Strategist Economic Commentary
+ 1 416 681 8919


Breakfast with Dave

More selling pressure in overseas equities to end the week — Asian markets are
down to nine-month lows after today’s additional 1.3% shellacking. Bond • While you were sleeping:
more selling pressure in
markets are consolidating though with a bullish bias — JGB yields down an extra
overseas equity markets to
2bps to 1.22%. end the week

The latest news is that Tim Geithner intends to meet with European officials next • Market thoughts: we could
see a near-term bounce
Wednesday to discuss the European debt crisis, and if he knows anything, he
that should be faded as
knows bailouts (Mexico in 1995, LTCM in 1998, banks in 2009). There is always the market is oversold
the risk of a coordinated FX intervention and there will be plenty of time for
European policymakers to meet over the long weekend to come up with another • U.S. initial jobless claims
data consistent with job
plan to burn those evil speculators (they are benevolent, however, when they are
losses, not gains
buying the debt) — see EU Chiefs Can’t Live With Markets, or Without on page A8
of the WSJ. Meanwhile, the first trillion bazooka, which just got approved by the • The leaders begin to lag:
German lower house of parliament, has done little to ease concerns of a Greek the index of U.S. leading
economic indicators (LEI)
debt restructuring because CDS spreads imply a 47% chance of default.
fell 0.1% in April — the first
decline since March 2009
On the data front, the key German Ifo business confidence index dipped, but just
a tad, in May to 101.5 from 101.6 in April (don’t ask us why the consensus • Deflation remains the
primary trend in the U.S. …
thought it would rise to 101.9). The U.K. also posted a record deficit for April,
and the Federal Reserve
and so the new U.K. government, like so many others, will have its feet to the knows it too
fire in terms of requiring a sizeable fiscal tightening going forward. This is key
for a world economy that has been revived mostly due to the rampant stimulus • The Philly Fed
manufacturing index
and bailouts of the past 12-18 months (this stimulus was candy for Mr. Market).
edged up in May, but the
As Fed Governor Daniel Tarullo said during a House hearing recently on the good news ended there as
European debt situation, “… their experience is another reminder, if one were the components were soft
needed, that every country with sustained budget deficits and rising debt — across the board
including the United States — needs to act in a timely manner put in place a
• Green shoots! The
credible program for sustainable fiscal policies.” number of insured
commercial banks and
Leading indicators are beginning to top out and this augurs for a more defensive savings institutions on the
investment strategy — it’s not too late. After all, copper is heading for its sixth FDIC’s “problem list”
weekly decline in a row — that must be telling you something about the global continues to grow
economic outlook (and specifically that Chinese imports are starting to decline). • Reversion to the mean:
going back 64 years, we
Home prices are beginning to weaken again under the weight of huge excess have never seen a time
supply (this process is also under way in Canada where the bloom is off the when the stock market
rose). And, 470k on U.S. jobless claims leaves doubt that we are actually corrected this much in the
so-called “sweet spot” of
embarking on a sustained job creation cycle no matter what the Bureau of Labor the cycle
Statistic (BLS) data show.
• But the fundamentals are
great! We hear this all the
time, but the
fundamentals are actually
less solid than many think
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

We shall find out soon enough if Mr. Carney left himself enough wiggle room to
sit out the June 1 policy meeting — the market and the consensus see a rate For the economy, it cannot
hike. We lay 60% odds that he sits this one out despite the earlier saber-rattling be a bad thing to have oil
and today’s higher-than-expected CPI data for April. For purely practical matters, prices come down, which
one has to wonder why the BoC would not opt to delay the rate hikes seeing as helps add cash to consumer
the Fed has already chosen to delay its planned balance sheet shrinkage. pocketbooks and protect
profit margins
If this European crisis has accomplished anything, it has taken the froth out of
commodity prices. Even gold is softening but every time it goes to test the 200-
day m.a. — now at $1,100 oz — it becomes a great buying opportunity.
Moreover, this has all but eliminated the overvaluation gap in the Canadian
dollar for the first time in four months.

Take note that there was not one particular piece of news that drove the
markets lower yesterday and this is key because it goes to the root of Bob
Farrell’s rule that “the markets make the news, the news does not make the
markets.” There are simply now more sellers than there are buyers because
portfolio managers went into this latest chapter of the global credit story fully
invested, the hedgies had already met their high-water marks, the shorts had
been covered long ago and the general investing public seem to be in a multi-
year phase of bolstering its underweight position in the fixed-income market.

Moreover, the “pig farmers” at the prop desks at the big banks, the ones who
drove the last leg of the bear market rally, seem to be placing their bets the other
way right now and with few bids, the prices are adjusting lower (the ‘flash crash’
was an exaggerated version of how a market can move when there is no bid).
Since much of the bear market rally off the March 2009 lows was technical rather
than fundamental in nature, one cannot rule out a move down towards the 900-
950 area for the S&P 500, which is where a classic retracement would take it; not
to mention where it would offer fair-value on a normalized P/E ratio basis.

As it stands, this is the first official correction in equities since the market came
off the lows 14 months ago:
• The S&P 500 is now down 12% from the nearby highs.
• The Russell 2000 is down 14%.
• TSX is down 7%.
• Oil is down 21%.
• Copper down 19%.
• The CRB is off 15%.
• The yield on the 10-year note is down 80bps.
• Investment grade corporate spreads have widened 61bps while high-yield
spreads have moved out 161bps.
• The VIX has surged 193%.
• The euro is down 15% and while the CAD has outperformed its commodity
counterparts, it has sagged 7% from the recent highs.

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• Since the market highs in the S&P 500, the best performing equity sectors
have been Telecom, Consumer Staples, and Industrials; the worst three have
While we did have a few
been Financials, Energy and Health Care — in a sign of how the complexion quarters of respite in U.S.
has shifted towards a less cyclical stance. consumer spending, make
no mistake that the trend is
Look, there’s no sense getting overly bearish and while those of us with cash on down, not up
hand that had been waiting for this opportunity in Godot-like fashion, the
correction comes as good news. But for the economy, it cannot be a bad thing
to have oil prices come down, which helps add cash to consumer pocketbooks
and protect profit margins, and of course this wonderful bond rally has acted as
a source of social policy seeing as it has helped pull mortgage rates down to six-
month lows, to 4.8% for the U.S. 30-year fixed rate product.

While we did have a few quarters of respite in consumer spending, make no

mistake that the trend is down, not up (real per capital household spending has
not even made a new high yet) and the frugality theme we introduced more than
two years ago is fully intact. For some evidence on this front, the just-released
USA Today/Gallup poll show that 27% of Americans plan to travel less this
summer; only 18% intend to travel more. This will likely put a dent in the hotel
and airline sectors, which, according to the latest CPI statistics, had been
showing some nice pricing power improvement in the past 2-3 months.

The must read of the day, if there is one, is the Paul Krugman’s column on page
A23 of the NYT — Lost Decade Looming? He starts off with “despite a chorus of
voices claiming otherwise, we aren’t Greece. We are, however, looking more
and more like Japan.”

We have been saying this since late 2008 when the Fed dropped the funds rate
to zero and that still couldn’t put a floor under either the economy or the equity The equity market is
and debt markets. What did put in a bottom was an experimental toolkit that technically oversold right
involved an unprecedented expansion of the central bank’s balance sheet, now and is due for a near-
which is now concentrated more in residential mortgages than in government term bounce, but that would
securities. One other thing — it is not one lost decade in Japan, it is two. be a rally that I would fade if
we see it
The equity market is technically oversold right now and is due for a near-term
bounce, but that would be a rally that I would fade if we see it. There has been
too much of a rupture to ignore with the S&P 500, Dow and Nasdaq all closing
below their 200-day moving averages (fist time in almost a year for the Nasdaq).
There were only 11 new highs yesterday and 212 new lows, so this ratio is still
quite bleak. Decliners/advancers were also 11-to-1 on the major exchanges.
This is what I mean by rupture.

On average, corrections that take place after such a massive move up from a
depressed low is 20%, which would mean that we could expect to see the S&P
500 still test the 970 level; with a prospect of a second-order Fibonacci
retracement implying a move below 950. Remember that before the last big leg
up in the market last summer, the S&P 500 was hovering around the 920 level,
which is my target to begin getting interested again.

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A 10% correction, even in a bull market, is pretty normal, and historically has To turn bullish, we would
occurred about every 12 months — and tends to occur more in the second year need to see Libor-OIS
of a rebound, or bull market, than in year-one. So the European debt crisis is spreads begin to narrow
certainly the catalyst for this renewed round of risk aversion, but is not out of again, corporate spreads
line with market patterns over the past century. tighten, and stability in the
Two critical data points to watch for — the May 6 flash-crash intraday low of
1,065 on the S&P 500, followed by the 1,044.5 low on February 5. If these
don’t hold, and the bulls need these levels to hold, then another leg down to or
through the 950-970 levels is likely.

To turn bullish, we would need to see Libor-OIS spreads begin to narrow again,
corporate spreads tighten, and stability in the euro. That would be important
signals from the other asset classes. Technically, it would be encouraging to see
two big up-days in the stock market with large volume — we need a follow-
through with huge participation. It would also help if market sentiments swung
towards the bearish camp — believe it or not, the most recent Investors
Intelligence survey has the bulls at 43.8% and the bears at 24.7%. At the lows,
we would expect these numbers to be reversed.

The fly-in-the-ointment is that unlike 1987 or 1998, this is not just a financial
crisis but one that is occurring with the global economy in a post-bubble fragile
state — if it is a recovery, it is a nascent recovery. And, already we see that the
U.S. leading economic indicator fell in April, which is unusual at this early stage
of the cycle, and jobless claims heading back above 470k, if sustained, is
worrisome because in the past this has coincided with job losses fully 75% of
the time. By the time the jobless recoveries were over and done with in 2003
and 1993, claims had already moved down to 400k in the former and 350k in
the latter. And, practically every house price measure in the U.S.A. is rolling over
right now. The lesson of 2002 is that market priced for perfection does not even
need a classic double-dip to falter — a simple growth relapse will do the trick.


U.S. initial jobless claims jumped 25k to 471k during the week of May 15 – just
in time for the nonfarm payroll survey week. This is the highest print in five
weeks and adds confirmation to the view that claims have stopped falling after a
huge decline in the second half of last year.

We went back into 50 years worth of data and found that when claims were this
high: (i) 75% of the time employment is declining; and, (ii) the average monthly
falloff is 150k … so, put that in your pipe and smoke it!

In addition, the total number of claimants fell 189k to 9.9 million, the low water
mark for the year and down from the nearby peak of 11.9 million. We wish this
was somehow related to the ranks of the long-term unemployed seeing a
tremendous wave of job opportunities and responding in kind (the consensus
view) but it could well simply be the case that these folks have run out of benefits
(after 99 weeks) with Congress deciding not to vote for yet another extension.

Page 4 of 9


The U.S. leading economic indicator (LEI) dropped 0.1% MoM in April, which The U.S. LEI fell 0.1% MoM in
came as a surprise to a consensus view of +0.2% MoM and was the first April — seeing the LEI
monthly decline since March 2009, at the market lows. Not only that, but the decline this soon after a
diffusion index dropped to 40% in May and this too was the poorest reading recession supposedly ended
since last March. Seeing the LEI decline this soon after a recession supposedly
is definitely not normal
ended is definitely not normal – it didn’t decline for four years after the last
recession ended in November 2001 (and that included the 2002 relapse).

Not only that, but the LEI is grossly overstated because the yield curve, just by
virtue of staying steep (the way it is calculated, it doesn't even have to move)
adds nearly a 0.4 percentage point to the LEI each and every month. So outside
of that, the LEI was down 0.5%; and, if you remove the tenth of a percentage
point upside influence from the stock market last month, the LEI would have
been down 0.6%, which is what it was doing back in the fourth quarter of 2008!

Back in April 2009, at the onset of the bear market rally and the green shoots, the
LEI was +1.1 MoM and the coincident index was -0.4% and the lagging index was -
0.6%. Fast forward to April 2010, and the LEI was -0.1%, the coincident index was
+0.3% and the lagging was +0.1%. The mirror image. Caveat emptor.

The Cleveland Fed just published a report on inflation concluding that: (i) the
decline in recent months has transcended the housing effect; and, (ii) the principal
risk is for a further slowing. Treasury yields are likely headed even lower. The title
of the report is Are Some Prices in the CPI More Forward Looking Than Others? We
Think So, by Michael F. Bryan and Brent Meyer and well worth a read.

Some of the items that make up the Consumer Price Index change prices
frequently, while others are slow to change. We explored whether these two The Cleveland Fed just
sets of prices — sticky and flexible — provide insight on different aspects of the published a report on
inflation process. We found that sticky prices appear to incorporate expectations inflation concluding that the
about future inflation to a greater degree than prices that change on a frequent decline in recent months has
basis, while flexible prices respond more powerfully to economic conditions— transcended the housing
economic slack. Importantly, our sticky-price measure seems to contain a effect and the principal risk
component of inflation expectations, and that component may be useful when is for a further slowing
trying to gauge where inflation is heading.

Where is inflation heading? Well, the last FOMC statement held the view that
“inflation is likely to be subdued for some time.” We certainly don’t have reason to
question that outlook. Indeed, while the recent trend in the core flexible CPI has
risen some recently (it’s up 3.3 percent over the past 12 months ending in March)
the trend in the core sticky-price CPI continues to decline. Even excluding shelter,
the 12-month growth rate in the core sticky CPI has fallen 1.1 percentage points
since December 2008, down to 1.8 percent in March. So on the basis of these
cuts of the CPI, we think “subdued for some time” sums up the price trends nicely.

Page 5 of 9


The Philly Fed manufacturing index edged up in May, to 21.4 from 20.2 in April
but the good news ended there as the components were soft across the board:
• New orders down to a 4-month low of 6.1 from 13.9 in April.
• Backlogs weakened to -3.0 from -0.9.
• Vendor performance swung from +5.4 to -1.9.
• Employment fell to a 6-month low of 3.2 from 7.3; the workweek to 7.0 from
• Six-month pricing power fell to 15.8 from 23.6, a four-month low.
• Capex spending plans fell to 7.7 from 10.2 in April, the lowest it has been in
seven months.
The number of insured commercial banks and savings institutions on the FDIC’s
“Problem List” increased from 702 to 775 during the quarter, and total assets of
“problem” institutions increased from $403 billion to $431 billion.


United States: FDIC: Total Number of Problem Institutions




300 252

200 136
80 76
100 52 50

2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Haver Analytics, Gluskin Sheff


We went back to 1946 and never found a time when the stock market (S&P 500)
corrected this much in the so-called “sweet spot” of the cycle (the time between
the end of the recession and the first Fed rate hike). The most it has ever gone
down in this positive part of the “investment clock” was 3%. Then again, you have
to go back to 1930 to have seen such a massive rebound from any low. In other
words, a 10% correction feels severe, but must be viewed in the context of an
abnormal cycle involving a credit collapse of historic proportions to have been only
briefly papered over by an unprecedented expansion of government balance
sheets globally. In the same being, this correction must be viewed in the context
of an 80% surge from the March lows.

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What is “normal” is that during the “sweet spot” period, the equity market is up
15% from the lows, not 80%. Depending on whether you calculate the 15% off the Currently, the fundamentals
first low in November 2008 or the second low in March 2009, it would not be a are actually less solid than
stretch to see this market trade down to below 900 on the S&P500 before the many on Wall Street are
interim low is turned in. In this latest phase, the steepest advance was 30%, letting on
which would therefore mean, if you want to be early at calling the low, a test of the
870 to 975 range would be your band in which to scale back in.


We hear this all the time; almost as many times as we hear “but we’re off the lows
for the session” on CNBC almost every day since the highs were put in three weeks
ago. It’s not always about how great the lagging or coincident indicators are
(especially when the ECRI leading index is down to a 40-week low). As we have
said time and again, to some testy retorts we must add, overvalued markets are
more vulnerable than undervalued markets. Simply put.

We had a nasty near 20% correction back in the summer and fall of 2002 and
yet we had come off a 3.5% annualized GDP quarter to start the year, which at
the time got a lot of folks in a tizzy. Real GDP printed +8% in the second
quarter of 2000 just as the Nasdaq was rolling off the highs, and never to look
back again at those lofty peaks – not to mention the huge 300k job gains at
the time. By the first quarter of 2001, GDP was falling at a 1.3% annual rate.
Who was calling for that a year before when the fundamentals were viewed as
being so solid by the economic elite at the time.

What about 1998? In the same quarter that the S&P 500 cratered 20%, due
no less than to the fallout from the Asian crisis, real GDP in the U.S. was up at
a ripping 5.4% annual rate and nonfarm payrolls were rising 250k per month
to perpetuity, or so it seemed. We had a big turndown in the financials back in
1994 and lo’ and behold, it took place with real GDP advancing at over a 4%
annual rate and payrolls increasing 300k per month.

Then in the mother of all corrections in October 1987; that same quarter of
the collapse, we had real GDP up at a resounding 7% annual rate and
employment rising 300k per month yet again. So, the message here is to
trade and invest carefully in an overvalued market, which is what each of
these periods had in common.

As for the current situation, the fundamentals are actually less solid than
many on Wall Street are letting on. It will be interesting to see what the fallout
is on spending and confidence from this latest market downdraft (it seems
more than a 10% correction, doesn’t it?) and intense volatility since the only
reason why everyone was of the belief that the economy had made the full
shift from recession to recovery was because the 80% surge in equity prices
told them that this was the case. Yes, the same stock market that peaked
right when the recession did in the fourth quarter of 2007 may yet again have
peaked right at the highs of this nascent, but fragile, renewal phase.

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Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the
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As of March 31, 2010, the Firm managed We have strong and stable portfolio
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