David A.

Rosenberg July 20, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

Q&A WITH THE BEAR
IN THIS ISSUE
Gregory Zuckerman at the Wall Street Journal just published a Q&A on the
market and the macro outlook, featuring me alongside James Paulsen, Chief • An interview with the Bear:
Gregory Zuckerman at the
Investment Strategist at Wells Capital Management, whom I like a lot, but
Wall Street Journal just
basically disagree with 99% of his views. Mr. Zuckerman only had so much published a Q&A on the
space and while he did a great editing job, what I thought I would do is pass market and the macro
below the full-fledged responses from my end. Enjoy! outlook, featuring me
alongside James Paulsen,
Where is the market headed the rest of this year and over the next 12-18 months? at Wells Capital
Management, whom I like
The market, like life and the seasons, moves in cycles — 16 to 18 year cycles, in a lot, but basically
fact. Sadly, this secular down-phase in the equity market began in 2000 when disagree with 99% of his
the major averages hit their peak in real terms, and so the best we can say is views
that we are probably 60% of the way into it. This by no means suggests that we
• How will the U.S. mid-term
cannot get periodic rallies along the way, but in a secular bear market, these election affect stocks, if at
rallies are to be rented, not owned. all? Tax rates on income
and capital are going up
In contrast, corrections in a secular bull market, as we saw in 1987 (as scary as next year, and gridlock will
it was) are opportunities to build long-term positions at more attractive pricing. not give us strong
In secular bear markets, the indices do hit new lows during the recessions (ie, leadership — hardly
positives for the economic
2002, 2009), when they occur; in secular bull markets, you do not make new or market outlook
lows — they are just corrections (ie, 1987, 1990, 1994, 1998).
• What could happen that
The market is not as cheap as the pundits, who rely on year-ahead EPS would turn you into a
bear/bull?
estimates, deem it to be. When one incorporates cyclically-adjusted corporate
earnings in ‘real’ terms, equities are still roughly 20% overvalued even after the • The U.S. equity market is
recent correction. still overvalued, according
to the latest Shiller P/E
ratio reading
More fundamentally, it would seem reasonable to expect that the equity market
will trade down to a valuation level that is historically commensurate with the • The roof collapses on U.S.
end of secular bear markets. This would typically mean no higher than a price- housing: the NAHB
earnings multiple of 10x and at least a 5% dividend yield on the S&P 500. So, housing market index
caved in again in July
we very likely have quite a long way to go on the downside.
• A meat-grinder market:
But it will not be a straight line and there will be intermittent rallies, as we typically, what happens
experienced a year ago April; however, not even that 80% bounce off the lows after a once-in-a-
managed to violate any of the long-term trend lines, which continue to portray a generation-type decline
are powerful rebounds, but
primary bear market, not unlike what we endured from 1966 to 1982. Back it never moves in a straight
then the principal cause was an inflationary spiral; this time it is a deflationary line
debt deleveraging that is the root cause. Within the next 12 to 18 months, I can
• Tough slog for
see the S&P 500 breaking back below 900, and a substantial test of the March
employment: a survey by
2009 lows cannot be ruled out. Accenture showed that
businesses in the U.S. do
not plan to restore their
workforce to pre-recession
levels anytime soon
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
July 20, 2010 – BREAKFAST WITH DAVE

What about the outlook for the U.S. and global economy?
I strongly believe that the economic recovery phase is behind us. Even if we
Even if we manage to avert a
manage to avert a double-dip recession, the chances of a growth relapse in the
double-dip recession, the
second half of the year are higher than the equity market, and to a lesser extent
chances of a growth relapse in
the credit market, have priced in. Treasuries seem to be the asset class that
the second half of the year are
most closely shares my cautious views. Anyone with a pro-cyclical bent has to higher than the equity market,
answer for why it is that the yield at mid-point on the coupon curve is below 2%, and to a lesser extent the
a year after a whippy rally in equities and commodities and what appeared to be credit market, have priced in
a sizeable policy-induced GDP jump off the bottom.

Given the unprecedented massive government intervention across the planet, it

can hardly come as a surprise that economic activity began to recover exactly a
year ago. But when the equity market was hitting its recovery highs in early
spring, it reflected a widespread view that the green shoots of 2009 would be
extended into a sustainable growth phase into the future. Not a good
assumption then; and not one now.

All of the optimism that dominated the marketplace over the past year
overlooked a significant fact. While U.S. banks have recapitalized themselves
and written off debt, this cycle has been dominated by governments socializing
the losses and taking the bad debts from the private sector and transferring the
liabilities to the public sector balance sheet. The debt problem was merely
shifted from the private sector to the government sector.

The Greek sovereign debt crisis has acted as the proverbial canary in the coal
mine, underscoring the view that governments have probed the outer limits of The dramatic government
their deficit financing capabilities. This has important implications for the incursion into the macro
economic outlook since the recovery has really been one part bailout stimulus, landscape and capital markets
to one part fiscal stimulus, to one part monetary stimulus, to one part inventory obscured the fact that the
renewal. Now that the boost to growth from the inventory bounce has run its economy is still in the throes
course, the stimulative effects of fiscal policy will diminish in coming quarters as of a multi-year credit
the public backlash against further increases in the debt-to-income ratio contraction phase
constrains the government’s ability to continue to try and fine-tune the economy.

The dramatic government incursion into the macro landscape and capital
markets obscured the fact that the economy is still in the throes of a multi-year
credit contraction phase and as such what we can expect is for the pace of
activity to weaken substantially during the periods when the stimulus fades.
This is what we can expect in the second half of the year and into 2011 when
tax rates rise substantially for many Americans.

Even if we don’t get a double-dip recession, and I think at a minimum what we’re
going to get is a 2002 style growth relapse when GDP growth converges on final
sales somewhere around a 1% rate; the consensus right now is for a 3% second
half growth, which is right where it was heading into the second half of 2002.

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July 20, 2010 – BREAKFAST WITH DAVE

The difference of course is back then the Fed had had room to cut rates 75 Bad government short-term
basis points, President Bush had the fiscal flexibility to cut taxes dramatically decisions over good long-term
and we went and started a war, which is always reflationary. We don’t have solutions are burying the world
these outlets today. into a graveyard of debt

Moreover, whatever pace of economic activity we see, I am sure that it will be

insufficient to absorb the still-large amount of excess capacity in the system. In
turn, what this means is that the U.S. unemployment rate will stay near double-
digit terrain for an extended period of time. It also implies that inflation and
interest rates will remain low for a sustained period of time, and, that a stock
market priced for peak earnings in 2011 could be in for some pretty big
disappointment.

As for the global economic outlook, the bloom is off the rose as well. The OECD
leading indicator in May turned in its softest pace since the depths of despair in
March 2009. China’s massive stimulus program has run out of steam and the
government has been tightening policy this year to redress substantial over-
investment in real estate and what may well be an unsustainable price bubble.
At the very least, China is unlikely to be the engine of global growth to as great
an extent as it has been. Much of Europe is in massive fiscal retrenchment
mode, and the peaking out in commodity prices will also have dampening
effects on the resource-producing countries, particularly in the once-hot Latin
American economies.

What keeps you up at night and what worries you most about the investing environment?
Bad government short-term decisions over good long-term solutions are burying
the world into a graveyard of debt. People have to understand that 80% or
higher debt-to-GDP ratios are a new dynamic and a game changer in Europe and
in the United States. The bottom line is that all levels of society, and across
most countries in the industrialized world, have far too much debt and far too
much debt-servicing costs in relation to income.

For the entire OECD countries, general government debt as a share of GDP
alone has ballooned from 73% when the recession started in 2007 and will
There is simply no quick fix to
climb to a record 104% next year. It took 15 years for this ratio to go from 63% resolve the massive global
to 73% and just four years from 73% to 103%. Total claims in the OECD at all imbalances that were allowed
levels of society just broke above 360% of GDP and that is clearly unstable. to build during the prior credit
Suffice it to say, many of these debts will not be serviceable — identifying where bubble
the defaults and haircuts take place, across countries and sectors, will require a
tremendous level of skill.

The problem of excessive debt leverage got worse in the aftermath of the
financial crisis, not better. This is what keeps me up at night — kicking the can
down the road in terms of addressing the global debt problem will only end up
making the situation worse. Governments seem to believe that the solution to a
debt deleveraging cycle is to create even more debt. But delaying the inevitable
process of mean-reverting debt and debt-service ratios back to historical norms
will be even more painful.

Page 3 of 9
July 20, 2010 – BREAKFAST WITH DAVE

There is simply no quick fix to resolve the massive global imbalances that were
My primary strategy theme has
allowed to build during the prior credit bubble. Yet, governments continue to
been S.I.R.P. (Safety and
adopt policies that do not address problems that are highly structural in nature
Income at a Reasonable Price)
and will require years of fiscal belt-tightening on the parts of consumers in much because yield works in a
of the industrialized world, and in the public sector as well. deleveraging deflationary
cycle
What makes you most enthused about the investing environment?
We are entering into a period of stable consumer prices that should last at least
for a generation. This will help prevent erosion in real household incomes.
There is a strong probability that after years of very solid productivity gains in the
industrial sector, the U.S. will experience a manufacturing renaissance of sorts
and re-emerge as a global export leader. The move towards frugality and
savings will make us less reliant on foreign borrowings and usher in a period of
stronger household balance sheets.

Where are you investing right now? Where do you plan to invest in 2011?
What should investors do with their portfolios?
My primary strategy theme has been S.I.R.P. (Safety and Income at a
Reasonable Price) because yield works in a deleveraging deflationary cycle. Not
only is there substantial excess capacity in the global economy, primarily in the
U.S. where the “output gap” is close to 6%, the more crucial story is the length of
time it will take to absorb the excess capacity. It could easily take five years or
longer, depending of course on how far down potential GDP growth goes in the
intermediate term given reduced labour mobility, lack of capital deepening and
higher future tax rates. This is important because what it means is that
disinflationary, even deflationary, pressures will be dominant over the next
several years.

Moreover, with the median age of the boomer population turning 55 in the U.S.,
there is a very strong demographic demand for income and with bonds
comprising just 6% of the household asset mix, this appetite for yield will very
likely expand even further in coming years. Within the equity market, this
implies a focus on squeezing as much income out of the portfolio as possible, so
a reliance on reliable dividend yield and dividend growth makes perfect sense.

We are in a period of heightened financial market volatility, which is typical of a

post-bubble deleveraging period when the forces of debt deflation are countered
by massive doses of government reflationary polices. This to-and-fro is the
reason why in the span of a decade we have seen two parabolic peaks in the
equity market (September 2000 and October 2007) and two depressed bottoms
(October 2002 and March 2009). As I have said before, 80% rallies in a 12-
month span, as we saw in the year to April, last happened in the early ‘30s and
were followed by gut-wrenching spasms to the downside. So for any investor,
return of capital is yet again reemerging as a very important theme, and the
need to focus on risk-adjusted returns. This, in turn, means a strategy that
minimizes both the volatility of the portfolio and the correlation with the equity
market is completely appropriate — the best way to play this is with true long-
short hedge fund strategies.

Page 4 of 9
July 20, 2010 – BREAKFAST WITH DAVE

Gold is also a hedge against financial instability and when the world is awash Regardless of the outcome of
with over $200 trillion of household, corporate and government liabilities, the mid-term elections in the
deflation works against debt servicing capabilities and calls into question the U.S., tax rates on income and
integrity of the global financial system. This is why gold has so much allure capital are going up next year,
today. It is a reflection of investor concern over the monetary stability, and Ben and gridlock will not give us
Bernanke and other central bankers only have to step on the printing presses strong leadership
whereas gold miners have to drill over two miles into the ground (gold
production is lower today than it was a decade ago; hardly the same can be said
for fiat currency).

Moreover, gold makes up a mere 0.05% share of global household net worth, so
small incremental allocations into bullion or gold-type investments can exert a
dramatic impact. Gold cannot be printed by central banks and is a monetary
metal that is no government’s liability. It is malleable and its supply curve is
inelastic over the intermediate term. And central banks, who were selling during
the higher interest rate times of the 1980s and 1990s, are now reallocating
their FX reserves towards gold, especially in Asia.

HOW WILL THE U.S. MID-TERM ELECTION AFFECT STOCKS, IF AT ALL?

Call it a mixed bag. First and foremost, we will probably experience political
gridlock in the U.S. at a time when the country desperately needs strong
leadership. On the positive side, however, we may well see the return of the two-
party system, and so the populist anti-business sentiment in Washington is likely
to subside.

Whether or not President Obama can move to the center as Bill Clinton did after
the 1994 mid-term defeat remains to be seen, but no matter what happens, we
are not going to have Ronald Reagan or George W. Bush to kick start a new bull
market with major tax relief. Regardless of the outcome, tax rates on income
and capital are going up next year, and gridlock will not give us strong leadership
— hardly positives for the economic or market outlook.

WHAT COULD HAPPEN THAT WOULD TURN YOU INTO A BEAR/BULL?

A new “killer app” or some major technological breakthrough would be nice.

A sustained decline in oil prices that is induced by new supplies as opposed to

demand destruction would act as a de facto tax cut.

Structural economic reforms in the world’s “surplus saving” countries, such as

China, India and Germany, that stimulate their domestic demand and hence
bolster our exports and reduce the global reliance on the U.S. as the consumer
of last resort would be a huge plus.

Signs that the debt deleveraging cycle has run its course. Progress in terms of
working our way through the domestic balance sheet repair process among
households and businesses, though history shows that this not merely a two or
three year adjustment following a credit bubble and ensuing financial on the
scale that we have just endured.

Page 5 of 9
July 20, 2010 – BREAKFAST WITH DAVE

STILL OVERVALUED
The latest Shiller P/E ratio continues to point to a market that is overvalued.
Are we now seeing brown
At the most current reading of 20.1x, the S&P 500 is 23% overvalued (relative
shoots emerging in the U.S.?
to the long-term average), up slightly from the 21% overvalued reading in June.
The answer is a resounding yes
In fact, on this basis, July marks the ninth consecutive month that the S&P
500 has been overvalued by 20% or more.

What will it take to get the market back to fair value? For the Shiller P/E to
mean revert to the long-term average of 16.4x, we would need to see a sell-off
of about 170 points, to 900 on the S&P 500.

THE ROOF COLLAPSES

The National Association of Home Builders’ housing market index caved in
again — sliding to 14 in July from 16 in June and 22 in May. This was not just
well below the 16 consensus guestimate, but was a fresh 15-month low —
despite the lowest mortgage rates on record. The vagaries of a post-bubble
credit collapse — time to tear out some of those chapters from the Econ101
textbooks. In a credit cycle, interest rates matter far less. The “buyer traffic”
subindex was truly abysmal — down to 10 from 13 in June. Back in March
2009, at the depths of the recession, this metric was sitting at 9.

Are we now seeing brown shoots? The answer is a resounding yes. Each of
the past 16 U.S. economic data releases have come in below expectations. Looking at the economic
That goes back nearly a month — maybe that’s why the U.S. dollar has been indicators in the U.S., taking
taking it on the chin. Not even Europe or Japan has a losing streak that long. June and July together, about
In fact, taking June and July together, about 70% of the incoming indicators 70% of the incoming data have
have been below consensus estimates. By way of comparison, about 70% of been below consensus
the indicators were surpassing expectations back in April, which may well help estimates
explain why that was the month that the stock market peaked.

MEATGRINDER MARKET
There was a really great article yesterday’s USA Today (Comparisons to the
Great Depression Keep Popping Up) on just how intense the market volatility
is in an “uncertain, post-bubble world”. Typically, what happens after once-in-
a-generation-type decline, as we saw in 2008 and into 2009, are powerful
rebounds. But it never moves in a straight line. Relief rallies are almost
always followed by big dips, which are then followed by fresh rallies and sell-
offs. Perpetual motion, and yet no positive returns, unless you sell in time (or
sell calls and collect the option premium).

To wit:

“New highs often don't materialize for years, if at all. Ten years after super-
pricey tech stocks crashed in 2000, the Nasdaq composite remains 56.8%
below its record high. Similarly, Japan's benchmark stock index, the Nikkei
225, is down 75.8% since its stock and real estate bubble burst in late 1989.

Page 6 of 9
July 20, 2010 – BREAKFAST WITH DAVE

Consider the aftermath of the 1929 stock market crash. After an initial drop
of nearly 48% the Dow enjoyed five bull market rallies, with gains ranging
from 23.4% to 48%, says Dow Jones Indexes. But each rebound was followed
by a sizable relapse, with declines from 37.4% to 53.6%. Each relapse led to
lower lows and the Dow's eventual record bear market decline of 89.2%. The
Dow took 25 years to hit a new high.”

Prepare for similar volatility in the future — the latest swings are a market
microcosm. After the Dow’s 53.7% drop in the 2007-09 bear market, it has
rallied as much as 71%, only to suffer a recent correction of 13.6%.

In this environment, hedge funds that actually hedge are prudent ways to
eradicate the volatility, minimize the correlations, and allow for respectable
real risk-adjusted returns that staying in cash just can't provide.

TOUGH SLOG FOR EMPLOYMENT

A just-released survey by Accenture showed that businesses don’t plan to
restore their workforce to pre-recession levels anytime soon. Of the 313
companies polled that reduced staff during the prior 12 months, 44% stated
that they do not intend on rebuilding their work force to pre-recession levels.

About 20% said they definitely would not, while 35% said they would fully restore
headcount in no more than two years.

Page 7 of 9
July 20, 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
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We offer a diverse platform of investment
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PERFORMANCE
$1 million invested in our Canadian Value which we have the highest conviction.
Portfolio in 1991 (its inception date)
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2
We have strong and stable portfolio
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We have a strong history of insightful collectively the largest
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investment portfolios.
For long equities, we look for companies
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share price below our estimate of intrinsic
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date) would have grown to
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$11.7 million2 on March
For corporate bonds, we look for issuers
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million for the S&P/TSX
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Total Return Index over
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Our success has often been linked to our

long history of investing in under-

March 31, 2010 versus $5.7 million for the
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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
July 20, 2010 – BREAKFAST WITH DAVE
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