David A.

Rosenberg December 23, 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
This has been the same story all week long — overseas the markets are
completely mixed to start off the day. Europe is all over the map but most of the • While you were sleeping:
bourses are in a sea of red over in Asia. We can’t help but notice that the mixed markets overseas,
VIX index has collapsed,
Shanghai index is down another 0.8%, and the oil price is flirting with a two-year fairly quiet in bond-land,
high of $90 a barrel. Chinese stock market has this nasty historical habit of shoppers are loosening
leading commodity prices by around 3-4 months with an 80% correlation. As an their purse strings but it is
aside, the run-up in energy prices is costing American consumers something dangerous to use this as a
close to $60 billion annual rate, just in case you wanted to know where most of sign of changing
consumer attitudes
that payroll tax cut is going to go — siphoned into the gas tank. Add to that the
reality of a really sick-looking Baltic Dry Index (see more below). • Baltic bust: Baltic Dry
Index may be indicating a
Everyone seems to believe in a sustainable V-shaped recovery here and yet we dramatic slowing of Asia’s
demand
have a significant Q3 downward revision to U.S. real consumer spending, a 0.2%
contraction in New Zealand’s real GDP for the same quarter (consensus was at • Housing still soft:
+0.1%), the Bank of Japan just cut its year-ahead GDP growth forecast to 1.5% Inventories remain a
from the 3% pace of the past year, and a Bank of England official on the wires hurdle and mortgage
applications are down
(Paul Fisher) is hinting of at least one quarter of U.K. GDP contraction in 2011
as well. The IMF also issued a growth risk signal for Canada due to high levels of • Ten reasons to be
consumer debt, a fragile housing market and exposure to a potentially stalling cautious for the 2011
market outlook
global economy and urged the Bank of Canada to refrain from any further policy
tightening. • Big recovery all right ―
0.9% on Q3 real final
As far as the FX market is concerned, it is interesting to see the commodity sales: mix of higher than
expected inventories and
complex giving up some gains even with the USD showing some struggle signs
lower than expected real
right after crossing above the 100-day moving average. It’s mostly quiet in final sales is a cloud over
bond-land, though we do see Portugal 10-year yields up 7bps today and Greece current quarter GDP
up 17bps to back above the 12% mark.

In a sign of these complacent times, the VIX index (a measure of volatility) has
collapsed to 15.45. It was last here in July 2007 when the majority of investors
only saw blue skies ahead and that the Fed and Congress had things under
control. The problems in housing and mortgages were deemed to be contained.
Looking for something cheap — there is nothing more inexpensive right now than
an insurance policy against the consensus being off the mark. The equity
market is hitting highs for the cycle on below-average volume, cash ratios are at
historical lows and market sentiment at three-year highs. If there is a bright light
from a technical perspective it is that the Nasdaq’s A-D line has improved to
levels we have not seen since last May.

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
December 23, 2010 – BREAKFAST WITH DAVE

CHART 1: VIX INDEX HAS COLLAPSED

CBOE Market Volatility Index, VIX
(index level)
100

80

60

40

20

0
07 08 09 10
Source: Wall Street Journal /Haver Analytics
Source: Haver Analytics, Gluskin Sheff

As a sign of these exuberant market times, Reuters just published the results of
a global portfolio manager poll that showed equity exposures in mixed-asset
strategies at 54.1% in December, the highest since last February (a couple of
months from the interim springtime peak); bond exposure is down to 33.9%,
again the lowest since last February, and again, just two months ahead of the
yield peak for 2010.

For now, the “spin” on the economic data from most pundits is on the positive
side. This is being hailed as the best holiday shopping season since 2006 as
ShopperTrack released numbers yesterday showing in-store sales running at
+5.5% YoY and comScore data suggest that online sales are running at 12%
above year-ago levels. Admittedly, these are surprising numbers but the take we
are seeing in the media is equally surprising. Look at what the folks at the New Let’s wait and see what
York Times had to say today (page B1): happens in the next few
months as the bills come in
“The last-minute holiday surge is heralding the return of the American consumer,
and the reality of deflating
home values and inflating gas
who is shedding the recession’s thrifty ways and rediscovering the pleasure of
prices start to sink in
shopping. The malls are jammed, parking lots snarled and sales expected to
stay strong in the few remaining days before Christmas.”

So people are loosening their purse strings during the holiday season and
journalists are going to use that as a commentary on how the entire thing is
playing out or how it will continue to play out. Let’s wait and see what happens
in the next few months as the bills come in and the reality of deflating home
values and inflating gas prices start to sink in.

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December 23, 2010 – BREAKFAST WITH DAVE

There are forecasts everywhere of better times ahead in terms of employment,

but the reality is that employment bottomed in December 2009. The problem is The consumer may indeed
that most of the jobs being created are part-time and the pace of job creation is have socked away some
not taking the unemployment rate down from near-10% levels, which in turn is money to avoid being Scrooge
exerting downward pressure on organic wages and salaries. This is then forcing for the current holiday season,
the government to borrow money to enact more tax stimulus and of course but we wouldn’t be
everyone is bulled up over tapping Social Security for spending purposes. We extrapolating this into 2011 by
shall see how far this goes.
any means

No doubt the savings rate is being drawn down in Q4 and this is helping fuel
consumer spending. But keep in mind that it is very dangerous to use the
holidays as a guide for any fundamental shifts in consumer attitudes. In the
days of free-flowing credit, the massive wealth build-up from double-digit home
price appreciation and sustainable strong employment that ultimately pulled the
jobless rate down to 4.5%, consumer spending in real terms surpassed a 2.5%
annual rate no fewer than 13 quarters and 3% on nine occasions. It has yet to
happen so far — keep that in mind. The consumer may indeed have socked
away some money — the savings rate did get as high as 7% — to avoid being
Scrooge for the current holiday season, but we wouldn’t be extrapolating this
into 2011 by any means.

In fact, what we found very interesting (if not amusing) was an article that found
its way on page A22 of the NYT — though it seemed to fly in the face of the
“frugality is over” column on page B1. The article on page A22 was titled This
Holiday, Secondhand items Gains Some Respect. Here’s what this particular
article concluded:

“Some retail experts see a cultural shift in the making as government deficits,
high unemployment and the mortgage crisis depress living standards. While
retail sales have lagged, they note, secondhand sales are flourishing: The
National Association of Resale and Thrift Shops reported that net sales were up
13 percent this year from 2009, the strongest in five years.”

BALTIC BUST
If you haven’t noticed, the Baltic Dry index is back to the 1,886 level. It hasn’t
been there since the end of July, and along with the 9% decline in the Shanghai
index from the nearby high, may well be an indicator of dramatic slowing in
Asian demand ahead (with obvious implications for the commodity complex).

Page 3 of 9
December 23, 2010 – BREAKFAST WITH DAVE

CHART 2: BALTIC BUST

Baltic Dry Index
(index level, January 4, 1985 = 1,000, data for 2010)

4,500

4,000

3,500

3,000

2,500

2,000

1,500
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: Haver Analytics, Gluskin Sheff

HOUSING STILL SOFT

U.S. existing home sales rose 5.6% in November to a 4.68 million annual unit
rate — lower than expected as the consensus was looking for a 7.1% increase.
Even so, this takes sales to their best level since last June. Excessive
inventories remain a hurdle — 9.5 months’ supply of total existing homes
currently sits down from a peak of 12.5 months back in July, but still higher than
long-term average of 6.4 months.

That was November data — prior to the bond-induced run-up in mortgage rates,
which have quashed what little incremental demand there was for residential
real estate. For the week ending December 17, mortgage applications plunged
The YoY rate on purchases did
18.6%, which is the steepest decline in a year and the fourth weekly falloff in a
improve to -8.4% from -17.0%
row. The level of the mortgage applications index now stands at 479.9, the the week before, but this was
lowest since the opening week of 2010. On a YoY basis, the trend in mortgage mostly due to base-effects
applications is now down nearly 20%, a far cry from the 60%-plus pace we saw
back in August.

Component wise, both purchases and refinancing are down for the latest
reporting week. Purchases are down 2.5% on top of the 5.0% drop from the
prior week. The level is now at 195.3, which is the lowest in five weeks and
down 7.4% from the nearby peak. The YoY rate on purchases did improve to
-8.4% from -17.0% the week before, but this was mostly due to base-effects as
this time last year we saw a huge decline in purchases. As for refinancings, they
were down 25% for the week, the sixth consecutive decline, and the level, at
2196.1 — now at its lowest point since the last week of April 2010. The YoY is
now at -24%, the lowest reading since mid-May and makes the 140% trend back
in mid-August a distant memory.

Blame it on the bond market as the 30-year mortgage rate has backed up now
by 64bps to 4.85% from where it was in early October.

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December 23, 2010 – BREAKFAST WITH DAVE

TEN REASONS TO BE CAUTIOUS FOR THE 2011 MARKET OUTLOOK:

1. In Barron’s look-ahead piece, not one strategist sees the prospect for a
market decline. This is called group-think. Moreover, the percentage of
brokerage house analysts and economists to raise their 2011 GDP
forecasts has risen substantially. Out of 49 economists surveyed, 35 say The last time S&P yields were
the U.S. economy will outperform the already upwardly revised GDP around this level was in the
forecasts, only 14 say we will underperform. This is capitulation of summer of 2000, and we know
historical proportions. what happened shortly after
2. The weekly fund flow data from the ICI showed not only massive outflows, that.
but in aggregate, retail investors withdrew a RECORD net $8.6 billion from
bond funds during the week ended December 15 (on top of the $1.7 billion
of outflows in the prior week). Maybe now all the bond bears will shut their
traps over this “bond-bubble” nonsense.
3. Investors Intelligence now shows the bull share heading up to 58.8% from
55.8% a week ago, and the bear share is up to 20.6% from 20.5%. So
bullish sentiment has now reached a new high for the year and is now the
highest since 2007 ― just ahead of the market slide.
4. It may pay to have a look at Dow 1929-1949 analog lined up with January
2000. We are getting very close to the May 1940 sell-off when Germany
invaded France. As a loyal reader and trusted friend notified us yesterday,
“fighting” war may be similar to the sovereign debt war raging in Europe
today. (Have a look at the jarring article on page 20 of today’s FT —
Germany is not immune to the contagion gripping Europe.)
5. What about the S&P 500 dividend yield, and this comes courtesy of an old
pal from Merrill Lynch who is currently an investment advisor. Over the
course of 2010, numerous analysts were saying that people must own
stocks because the dividend yields will be more than that of the 10-year
Treasury. But alas, here we are today with the S&P 500 dividend yield at
2% and the 10-year T-note yield at 3.3%.
From a historical standpoint, the yield on the S&P 500 is very low ― too low,
in fact. This smacks of a market top and underscores the point that the
market is too optimistic in the sense that investors are willing to forgo yield
because they assume that they will get the return via the capital gain. In
essence, dividend yields are supposed to be higher than the risk free yield
in a fairly valued market because the higher yield is “supposed to”
compensate the investor for taking on extra risk. The last time S&P yields
were around this level was in the summer of 2000, and we know what
happened shortly after that. When the S&P yield gets to its long-term
average of 4.35%, maybe even a little higher, then stocks will likely be a
long-term buy.

Page 5 of 9
December 23, 2010 – BREAKFAST WITH DAVE

CHART 3: A CHEAP MARKET?

S&P 500 Composite, Dividend yield
(percentage)
8

0
50 55 60 65 70 75 80 85 90 95 00 05 10
Source: Standard and Poor's/Haver Analytics

Source: Haver Analytics, Gluskin Sheff

6. The equity market in gold terms has been plummeting for about a decade
and will continue to do so. When measured in Federal Reserve Notes, the
Dow has done great. But there has been no market recovery when
benchmarked against the most reliable currency in the world. Back in
2000, it took over 40oz of gold to buy the Dow; now it takes a little more
than 8oz. This is typical of secular bear markets and this ends when the
Dow can be bought with less than 2oz of gold. Even then, an undershoot
could very well take the ratio to 1:1.
7. As Bob Farrell is clearly indicating in his work, momentum and market
breadth have been lacking. The number of stocks in the S&P 500 that are
making 52-week highs is declining even though the index continues to
make new 52-week highs.
8. Stocks are overvalued at the present levels. For December, the Shiller P/E
ratio says stocks are now trading at a whopping 22.7 times earnings! In
normal economic periods, the Shiller P/E is between 14 and 16 times
earnings. Coming out of the bursting of a credit bubble, the P/E ratio
historically is 12. Coming out of a credit bubble of the magnitude we just
had, the P/E should be at single digits.

CHART 4: A CHEAP MARKET?

S&P 500 Composite, Price/Earnings Ratio
(ratio)
125

100

75

50

25

0
50 55 60 65 70 75 80 85 90 95 00 05 10
Source: Standard and Poor's/Haver Analytics

Source: Haver Analytics, Gluskin Sheff

Page 6 of 9
December 23, 2010 – BREAKFAST WITH DAVE

9. The potential for a significant down-leg in home prices is being

underestimated. The unsold existing inventory is still 80% above the
historical norm, at 3.7 million. And that does not include the ‘shadow’
foreclosed inventory. According to some superb research conducted by the
Dallas Fed, completing the mean-reversion process would entail a further
23% decline in real home prices from here. In a near zero percent inflation
environment, that is one massive decline in nominal terms. Prices may not
hit their ultimate bottom until some point in 2015.
10. Arguably the most understated, yet significant, issue facing both U.S.
economy and U.S. markets is the escalating fiscal strains at the state and
local government levels, particularly those jurisdictions with uncomfortably
high pension liabilities. Have a look at Alabama town shows the cost of Consumer spending was taken
neglecting a pension fund on the front page of the NYT as well as Chapter down 0.4 of a percentage
9 weighed in pension woes on page C1 on WSJ. point to 2.4%, which of course
In the absence of Chapter 9 declarations or dramatic federal aid, fixing the
you never would have guessed
fiscal problems at lower levels of government is very likely going to require from those “ripping” retail
some radical restraint, perhaps even breaking up existing contracts for sales numbers
current retirees and tapping tax payers for additional revenues. The story
has some how become lost in all the excitement over the New Tax Deal
cobbled together between the White House and the lame duck Congress
just a few weeks ago.
BIG RECOVERY ALL RIGHT ― 0.9% ON Q3 REAL FINAL SALES
Real GDP was revised up a tenth of a point to 2.6% at an annual rate for Q3 but
it really felt more like a downgrade than an upgrade when you sift through the
details. Consumer spending was taken down 0.4 of a percentage point to 2.4%,
which of course you never would have guessed from those “ripping” retail sales
numbers. The problem with those monthly reports is that they only represent a
fraction of total personal expenditures ― what led the downward revision were
services.

There were no other major changes except to inventories, which are now
reported to be $121.4 billion at an annual rate from $111.5 billion initially. Real
final sales were taken down to a mere pittance of a +0.9% annual rate from
+1.2% in the last Q3 GDP revision go-around. This mix of higher than expected
inventories and lower than expected real final sales is a cloud over current
quarter GDP ― just after all the latest round of upward growth revisions by the
consensus economics community.

Page 7 of 9
December 23, 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, 2010, the Firm
managed assets of $5.8 billion.
Gluskin Sheff became a publicly traded
corporation on the Toronto Stock
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remains 49% owned by its senior
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public company accountability and
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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
investment styles (Value, Growth and
1 September 30, 2010
Income).
The minimum investment required to
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Firm is $3 million.
PERFORMANCE
$1 million invested in our Canadian
Equity Portfolio in 1991 (its inception
date) would have grown to $9.1 million
on September 30, 2010 versus $5.9 million
for the S&P/TSX Total Return Index
over the same period.
$1 million usd invested in our U.S.
Equity Portfolio in 1986 (its inception
date) would have grown to $11.8 million
usd on September 30, 2010 versus $9.6
2 In terms of asset mix and portfolio
million usd for the S&P 500 Total
Return Index over the same period.
Notes:
Unless otherwise noted, all values are in Canadian dollars.
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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.
We have strong and stable portfolio
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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
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employees are
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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$1 million invested in our
Canadian Equity 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.
$9.1 million2 on
For corporate bonds, we look for issuers
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versus $5.9 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.
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2
Our success has often been linked to our
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followed and under-appreciated small
and mid cap companies both in Canada
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fundamental analysis and our top-down
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Page 8 of 9
December 23, 2010 – BREAKFAST WITH DAVE
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