David A.

Rosenberg October 14, 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
Same old, same old. Equity markets are still rocking and rolling and yesterday’s
late-afternoon sell-off in the U.S. has not dented investor sentiment one iota. The • While you were sleeping:
same old, same old, equity
Asian MSCI index surged 1.9% today to a four-month high and U.S. futures are
markets are still rockin’
flashing green. The general feeling is that you can’t be off the train until at least and a rollin’; everything
early November. This is now purely a sentiment-driven market and there will be a right now is correlated off
point in time where we will see the Fed’s move to cut its macro forecast three the U.S. dollar; the
times at the last three meetings show through in corporate guidance, though in the mortgage “scandal” is
aftermath of Alcoa and CSC, that is understandably a hard view to sell at this time. growing now that all 50
states are probing the
lending practices of the big
There is still a reasonable chance of a GDP contraction this quarter and a sub-50 banks
ISM index reading by year-end. The market is priced for the economy to somehow
muddle through; investors are expecting something big out of the Fed ($500 • Who’s doing the buying in
the equity market? It
billion to $1 trillion of QE) on November 3rd and for the GOP to at least take the
seems that be three
House the day before the midterm elections. We could be in for a classic buy-the- principal buyers: pension
rumour/sell-the-fact trade around that time, but no doubt that at the current time, funds, hedge funds and
momentum and speculative fervor are squarely in the bull camp. proprietary trading desks
at the big commercial
Everything right now is correlated off the U.S. dollar, which is down another 60 banks
ticks today and despite how oversold it is and all the other blemishes on the • The VIX, Alcoa and Bob
other currencies around the world, the reality is that nobody is going to be Farrell: the VIX index is
printing as much money as Bernanke and as such the chart of the greenback now below the 20 mark for
continues to point south-southeast. Moreover, once the DXY breaks below 74 three days running — could
be a possible sign of
(now 76.5) there is only dead-air down to the 70 level. The U.S. dollar is now at
complacency
a new 15-year low against the yen, and at ¥81, it is trading at the same level it
was at the height of the Peso crisis in 1995. The greenback is also at an eight- • A reason to be cautious
month low against the euro; and at a record low against the Swiss franc, which the U.S. equity market: The
latest Investors
has emerged as a safe haven currency.
Intelligence poll showed
that bullish sentiment rose
What we know is that historically, there is a 10% inverse correlation between the to 47.2% for the latest
U.S. dollar and the S&P 500 and in recent months, that inverse relationship has reporting week and the
intensified to 90%. A weaker dollar breathes global liquidity into the system and bear share dropped to
at the same time provides the fodder for commodities to run further. Take a 24.7%
look at Dr. Copper — up to a 27-month high — but everything else from crude to • No inflation in U.S. import
corn to cotton is firming as well, and hence the up-move in the Canadian dollar prices in September
back to par for the first time in six months. As such, there has been a radical
tightening in Canadian monetary conditions at a time when the economy is
cooling off vividly and one has to wonder if the Bank of Canada could take back
a rate hike or two if it had known the loonie was going to strengthen by 5% over
the last three months. One last point on the FX front, it will be interesting to see
how the news that China’s FX reserves soared by a record $194 billion in the
past three months to $2.65 trillion (almost double the size of the Canadian
economy!) is going to play-out in Washington.

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
October 14, 2010 – BREAKFAST WITH DAVE

There have been two mini bull markets and two mini bear markets so far this
year in the equity market. The range on the S&P 500 has basically been 1,000 There have been two mini bull
to 1,200 and we are now quickly challenging the high end of the range. In each markets and two mini bear
case, the direction of the U.S. dollar played a key role in the direction of the markets so far this year in the
market — it is no mere coincidence that the rolling-over in the dollar in late equity market …
August occurred within two days of the dramatic rebound in the stock market.
The equity market has managed to rally through a slate of soft economic data so
it would stand to reason that what upsets the apple cart would be a
countertrend rally in the greenback, which is as oversold as the euro was when it
briefly broke below 1.20 last June.

As for the bond market, what is making the rounds this morning is the news that
PIMCO has trimmed its exposure to the U.S. Treasury market. More often than
not, this news leaks out long after the venerable bond fund manager has made its
move and as such is a classic contrary indicator. Meanwhile, as a sign of how
desperate investors are for yield of any kind, demand at today’s 30-year JGB
auction (a sub-2% yield) was the strongest in eight years (bid-offer ratio at 5.4x).

However, there is no doubt that when one looks at U.S. TIPS breakevens, market- … And in each case, the
based inflation expectations have risen 40-50 basis points since late August and direction of the U.S. dollar
the spread between the long bond and the 10-year note has gapped up played a key role in the
significantly. So along with these items and the runup in gold and commodities direction of the rally in the
and the downdraft in the U.S. dollar, the Fed has managed to already rekindle market
inflation expectations to a certain degree. But this will only really help the
economy if it reaches the real economy and businesses respond to negative real
rates by sustaining strong rates of growth in capital spending and consumers
begin to spend more now to avoid price hikes down the road. And, there is always
the question as to how much of the QE-induced reserve expansion will show up in
credit creation. From our lens, even if the Fed is successful at bolstering risk
appetite and asset inflation, there would still be as much as $2-3 trillion of
deleveraging to go before household debt ratios completely mean reverted. Who
knows? Maybe this time next year we will be into QE3 or QE4.

All we know is that we have a U.S. central bank chairman who is a life-long
academic but is willing to be extremely aggressive. While the asymptotic chart Oil prices just moved above
of gold makes us near-term nervous, the secular bull market in bullion (hard $84 a barrel, which means that
assets in general) is very likely going to remain intact as the continued we are likely going to be
expansions of central bank balance sheets allow speculative “animal spirits” to seeing much higher gasoline
flourish; however, at the expense of the integrity of the global monetary system. prices ahead

Oil prices just moved above $84 a barrel, which means that we are going to be
seeing much higher gasoline prices ahead. Food prices either rise from here or
the grocery chains will face substantial margin pressure. And unlike the last
commodity boom of 2007, this is happening with the unemployment rate at
9.6%, not sub-5%.

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October 14, 2010 – BREAKFAST WITH DAVE

The equity market gains have been nice, but it is doing more to pad the pockets
of the trading community than the proletariat since Ozzie and Harriet have been Who’s doing the buying in the
selling into this bear market rally of the past 20 months. And, what happens U.S. equity market? We know
once the long-term unemployed soon begin to see their 99 weeks of jobless it’s not the retail/private
benefits fall by the wayside? investor, and mutual funds

Meanwhile, the mortgage “scandal” is growing now that all 50 states are probing
the lending practices of the big banks and JPMorgan and GMA have joined Bank
of America in halting foreclosures and others are sure to follow. This will help
foreclosed households stay in their homes rent-free for longer, but watch sales
activity dry up in coming months since it was foreclosed sales that were really
impacting the turnover in recent months.

WHO’S DOING THE BUYING?

Good question.

We know it’s not the retail investor/private client … they have been selling into It seems that the three buyers
this entire bear market rally and rebalancing their asset mix in favour of income. at the moment are: pension
funds, hedge funds and the
It’s not the mutual funds because institutional PMs already have cycle-low cash prop desks at the big
ratios (at 3½%). commercial banks

There would seem to be three principal buyers right now:

1. Pension funds: There was an article in yesterday’s WSJ (page A9) titled
Cities Hide Pension Liabilities, Study Says.” The latest estimate of unfunded
pension liabilities for municipalities is $574 billion and for state
governments it is $3 trillion. Believe it or not, but “most” are using assumed
rates of return of 8%, which is actually more than what you can get on a
generic B-rated corporate bond right now. So, this means that there must
be a huge rebalancing going on right now in the pension fund industry that is
acting as a major source of fund-flow support for equities.
2. Hedge funds: As Bob Farrell recently pointed out, the hedge funds woefully
lagged behind in September, with a 3.5% gain compared to a 9% advance for
the overall market. There is plenty of anecdotal evidence that the hedgies are
allocating funds towards the equity market. No sense disputing that.
3. The proprietary trading desks at the big commercial banks. Look at the
chart below from the weekly Fed data — bank-wide trading assets have
soared $50 billion alone in the past month.

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October 14, 2010 – BREAKFAST WITH DAVE

CHART 1: BANK-WIDE TRADING ASSETS SOARING

United States: All Commercial Banks: Trading Assets
(US$ billions)
440

400

360

320

280

240
JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP
10

Source: Haver Analytics, Gluskin Sheff

THE VIX, ALCOA AND BOB FARRELL

Page C7 of yesterday’s WSJ discusses the VIX index, which has broken below
the 20 level now for three days running, as a possible sign of complacency. It No wonder Alcoa is viewed as
probably is — we have only seen a sub-20 reading on the VIX a mere 14% of a bellwether stock: when
time since the stock market peaked in October 2007, so this is not an usual Alcoa’s stock rises the day
development. But even though the VIX index is at 19.07, the lessons of the after its earnings release, the
last two forays below 20 suggest that it has yet to hit an extreme low just yet. overall market rises 80% of the
time in the next 10 sessions …
It dipped below 20 on February 26th of this year and went as low as 16.6x on
February 3rd and during that time we had a 10% gain in the S&P 500. It was
at that 16.6x threshold that the selling started because we then endured a
16% correction to the July lows. Go back before then to December 22, 2009
and the VIX broke below 20 and then went as low as 17.6 on January 19th —
during which the S&P 500 advanced 3%. It then went for an 8% setback in
the next few weeks.

Message: the VIX below 20 is something new here, but if the past two
episodes this year are any indication, the best way to play it is to wait for the
break below 18 or 17 before taking chips off the table.

The WSJ (same page as above) makes much of the “gold cross” (the 50-day
… And when the stock declines
on the Dow breaking above the 200-day) though the “death cross” (in reverse)
the day after its results, the
during the summer did not exactly trigger the expected plunge as was market only manages to
expected back then. However, the article does contain a good tidbit of advance 38% of the time
information in terms of trading from the long side (for now). When Alcoa’s
stock rises the day after its earnings release, the overall market rises 80% of
the time in the next 10 sessions. And when Alcoa’s stock declines the day
after its results, the market only manages to advance 38% of the time. I
guess that’s why as ‘old economy’ as it is, it’s viewed as a bellwether — at
least for a trade.

Page 4 of 7
October 14, 2010 – BREAKFAST WITH DAVE

The one fly in the ointment is the Investors Intelligence Poll, which does limit
but not prevent upside potential. Bob Farrell is not ready to call an end to the The one fly in the ointment in
secular bear market but does say that the break of resistance has been the current equity market rally
critical, not to mention doing so on days when the economic data were poor. is investor sentiment, which
His biggest near-term concern is a possible countertrend reversal in the U.S. does limit, but not necessarily
dollar — he views that as the most pronounced risk for a market correction. prevent upside potential

A REASON TO BE CAUTIOUS ON THE EQUITY MARKET

Investors Intelligence poll just came out and the results:

Bulls: 47.2% versus 45.6% last week

Bears: 24.7% versus 28.3% last week

The bull/bear spread now stands at 22.5. This ratio has not been this “wide”
since May 11. Bullish sentiment has risen for 7 consecutive weeks (and is up
17.8 points since the end of August). Reasons to be cautious (for those who
play it from the long side).

NO INFLATION IN IMPORT PRICES

The September U.S. import price data came out fairly benign — down 0.3% MoM
on the back of a 3.1% slide in petroleum prices (that won’t last long, though).
Food prices rose 0.8% for the third increase in as many months and that will last
quite a bit longer.

But the stuff related to the economic cycle remained weak: industrial supplies
deflated 1.3% MoM, the imported price of capital goods was flat, autos rose
+0.2% MoM for the second month in a row and consumer goods excluding autos
barely up at +0.1% for the second month in a row and at or below this pace now
for six consecutive months.

Page 5 of 7
October 14, 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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OVERVIEW INVESTMENT STRATEGY & TEAM

As of June 30, 2010, the Firm managed
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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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Portfolio Managers have been with the interests are directly
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aligned with those of
have attracted “best in class” talent at all
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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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Return Index over the
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Our success has often been linked to our

long history of investing in under-followed

June 30, 2010 versus $5.4 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 6 of 7
October 14, 2010 – BREAKFAST WITH DAVE
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