Breakfast With Dave 101310

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David A. Rosenberg October 13, 2010Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

The risk-on trade is back with the equity market even more comfortable now that

QE2 is on its way after sifting through yesterdays FOMC minutes. The fact that

the Fed staffers, yet again, took a knife to the macro outlook did not even

register a yawn. So we have a market backdrop completely dependent on

sentiment and psychology as the P/E multiple expands and at the same time a

market backdrop that has become unglued from economic reality.

The Fed is so desperate that it is even contemplating measures that would

attempt to boost inflation expectations nice in theory, but in practice this maybe difficult. Totally experimental, but Mr. Market seems to be putting blind faith

in the Fed as it did back in the fall of 2007.

As far as todays market action, the key correlation of course is with the U.S.

dollar, which is heading back south, but at the same time, so are the yen and

Swiss franc the other defensive currencies. The euro is bid as signs continue

to emerge that no more easing is coming out of the ECB Frances inflation rate

rose to 1.8% in September from 1.6% on the back of the food complex. And, the

emerging market currency complex is firm today as well ditto for the

commodity currencies as the loonie and Aussie dollar continue on in their race

towards par. CDS spreads are tightening overseas as perceived corporate

default risks recede further.

Meanwhile, in the global equity market, it is a literal sea of green right across the

screen back to six-month highs for the MSCI World Index. The other news that

lifted confidence was the trade report showing that Chinas exports jumped 25%

in September and Japanese machinery orders soared 10.1% in August (there

was also a 3.3% rebound in Australian consumer sentiment). The post-data

backup in JGB yields have been transmitted to other sovereign bond markets in

the wee hours of the morning.

The commodity sector is gaining ground with the U.S. dollar back in retreat

mode. Copper is testing 27-month highs, the entire food complex is rallying

again, and gold is just 0.4% shy of making a new all-time high. Oil is recovering

on the back of an increase in the IEA forecast for global demand (by 300,000

barrels per day for this year and next to 86.9 million barrels per day, and88.2mbd, respectively) as well as the news that China imported a record 23.3

million metric tons of crude last month.

Please see important disclosures at the end of this document.

Gluskin Sheff + Associates Inc. is one of Canadas pre-eminent wealth management firms. Founded in 1984 and focused primarily on high networth 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,

visitwww.gluskinsheff.com

Some sector screensbased on low correlations

to U.S. growth, highcorrelations to emergingmarket growth, decentyield and attractive P/Es

Small business, smallconfidence level: the NFIBsmall business optimismsurvey just came out andconfidence is still atrecessionary levels

Whats ahead in Q3earnings season? Theconsensus is looking for

24% YoY earnings growthin the U.S.; revenues areseen lagging behind onceagain; profit growth isslowing down, butconsensus estimates areprobably still too high

IN THIS ISSUE

While you were sleeping:the risk-on trade is backwith the market even morecomfortable now that QE2is on its way after sifting

through yesterdays FOMCminutes


2/8

October 13, 2010 BREAKFAST WITH DAVE

The politics may well be turning more positive for the markets as well; we see

two developments that suggest as much. The White House said it is backing

off from any plans to impose a moratorium on home foreclosures (what the

industry decides to do is its business). And, President Obama just lifted the

ban on deepwater drilling. Bill Clinton is increasingly on his way towards being

the Democrats white knight as election day approaches (see page 5 of the

FT) and who knows how to move to the middle better than him. Who knows?

If the President is already showing signs of flexibility and can manage to pull a

few feathers out of Mr. Clintons cap, perhaps the Bush-era dividend, capital

gains and high-income tax rates will see a post-2010 reprieve. For a

sentiment-driven market, this would likely be important.

A must-read today is Martin Wolfs column on page 11 of the FT Why

America is going to Win the Global Currency Battle. To wit:

The global consequences are evident: the policy will raise prices

of long-term assets and encourage capital to flow into countries

with less expansionary monetary policies (such as Switzerland) or

higher returns (such as emerging economies). This is what is

happening. The Washington-based Institute for International

Finance forecasts net inflows of capital from abroad into

emerging economies of more than $800bn in 2010 and 2011. It

also forecasts massive intervention by recipients of this capital,

albeit at a falling rate.

Also see The Currency Race That Everybody is Trying to Lose on page 25 for

why gold is likely going to make new higher highs.

The Fed is pushing on a string and is in a classic liquidity trap but the markets

love the prospect of more reserves flowing into risk assets even if the

economy is left in the dust. In this respect, the quote of the day goes to

former Dallas Fed President Mike McTeer on page B2 of the NYT regarding the

move afoot to QE2 If you lead the horse to water and it wont drink, just

keep adding water and maybe even spike it Yikes! This will not end well,

even if it is next to impossible to say when it does.

Page C1 of the WSJ runs with Fed Moves Viewed as Softening the Dollar. The

article posits that Investors increasingly believe the U.S. is putting itself at

the forefront of the competitive devaluation race. That view is driven in part

by the Treasurys increased pressure on China to allow its currency to rise

against the dollar, which would likely result in the dollar falling against arange of other emerging market currencies.

Since 1985, dollar-yen has sunk nearly 70% and yet the US has the same

bilateral deficit with Japan today as it had then. So why does everyone think

that a Chinese revaluation will necessarily clear out any perceived

imbalances? Maybe if U.S. policy encouraged thrift over asset-based

consumption growth, these trade imbalances would dissipate more quickly.

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Bill Clinton is increasingly on

his way towards being theDemocrats white knight

as election day approaches

(see page 5 of the FT) and

who knows how to move to

the middle better than him

The Fed is pushing on a

string and is in a classic

liquidity trap but the markets

love the prospect of more

reserves flowing into risk

assets even if the economy

is left in the dust


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And the front page of the WSJ has this as a lead article Fed Chief Get Set to

Apply Lessons of Japans History. While there are differences, the similarities

between the two economies are striking. The article dusts off a speech that

Ben Bernanke gave over a decade ago on Japans policy paralysis and one of

his suggestions was to cheapen the yen as well as to buy long-term debt.

This certainly seems to be the current roadmap in the U.S.A.

Finally, an article that truly resonates with us from the front page of the NYT

(Across the U.S., a Long Recovery Looks Much Like a Recession). For how

long the equity market can become unglued from the real economy remains to

be seen, but there is little doubt in our mind that it is going to take years to

repair all the damage and absorb all the excess supply (of homes, office

buildings, plants and labour). The article is well worth a read, regardless of

your market view.

SOME SECTOR SCREENS

While getting the asset mix right is always extremely critical, so is getting the

sectors right within the equity allocation. With this in mind, what makes sense is

to own the sectors that have this combination of characteristics:

1. Low correlations to the sluggish U.S. economic growth profile.2. High correlations to the stronger emerging market growth profile.3. Comparable or better dividend yield than you can get in the bond market.4. Below average P/E ratios in the search for relative value.The sectors that stand out as possessing the best attributes after running

screens on the above-mentioned factors (for both Canada and the United

States) are Staples, Health Care and Energy, followed closely by utilities.

Thesectors that screened poorly were Industrials, consumer discretionary

and financials.

SMALL BUSINESS, SMALL CONFIDENCE LEVEL

The National Federation of Independent Business (NFIB) survey came out for

September and it was predictably soft edging up fractionally to 89.0 from

88.8 in August. To put that number in context, it was 92.9 in September 2008

when Lehman collapsed; it was 96.3 on September 2001 when the terrorist

attacks occurred; and it was 99.5 in September 1998 when the Fed was

forced to bail out LTCM and Russia defaulted.

This is a recessionary level; that is for sure. But as usual, the devil was in the

details:

Hiring intentions fell from +1 in August to -3 in September. This is a 10-month low.

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While getting the asset mix

right is always extremelycritical, so is getting the

sectors right within the

equity allocation

Despite the fractional

increase, small business

sentiment in the U.S.

remains at recessionary

levels


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CHART 1: NO PLANS ON A HIRING SPREE FROM SMALL BUSINESSES

United States: National Federation of Independent Business Small BusinessOptimism Survey: Percentage Planning to Increase Employment

(net, percent)

10987654

20

15

10

5

0

-5

-10

Source: Haver Analytics, Gluskin Sheff

Pricing intentions, even with the spike in commodities, fell from +10 to +7 inSeptember, the lowest in nine months.

Wage increase intentions fell from +6 to +3 in September, a three-month low.CHART 2: SMALL BUSINESSES NOT LOOKING TO INCREASE WAGES

United States: National Federation of Independent Business Small Business

Optimism Survey: Percentage Planning to Raise Worker Compensation

(net, percent)

10987654

20

16

12

8

4

0

Source: Haver Analytics, Gluskin Sheff

Those claiming that credit was hard to get rose from +12 to +14, the highestin five months.

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A lot of pundits are talking about reflation or inflation, but it is the small

business sector that has a strong say in the direction of pricing power. Only

4% cited inflation as a concern in September and just 3% cited labour costs.

At the same time, the weak sales outlook was the top concern for 30% of

small businesses, and 23% stated that taxes were on the top of the worry list.


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WHATS AHEAD IN Q3 EARNINGS SEASON? When profit margins are at a

cycle high, we find that on

average, profits invariably

end up lagging well behind

nominal GDP growth

The consensus is looking for +24% YoY earnings growth. Revenues are seen lagging behind once again, at +7%. Strip out financials and operating EPS growth is seen at a more modest

+18% (half the pace of the first half of the year).

Profit growth is slowing down, but not collapsing. That said, consensusestimates are probably still too high.

Two wild cards could be reduced guidance from the Tech and Transports

sectors we say that because of the comments on these two sectors coming

out of the recent ISM survey:

Computer & Electronic Products: Strategic customers reducing order

quantities.

Transportation equipment: Customers seem to be pulling back on orders. I

suspect that they are trying to reduce their inventory for the approaching year-

end.

Going forward, here is the challenge. The consensus is still looking for $95-

plus on U.S. operating EPS growth for 2011, but at a time when profit margins

are at a cycle high, not a trough. There is a difference. At troughs in margins,

profits, on average, expand at six times the pace of nominal GDP growth in the

ensuing year. But when margins are at a cycle high, we find that on

average, profits invariably end up lagging well behind nominal GDP growth

and, in fact, decline in the next year by 3% on an average basis, and close

to 5% on a median basis. As a result, it may be more prudent at this juncture

to be valuing the equity market on $75 of S&P 500 operating earnings next

year than on $95. Slap on an appropriate multiple and you can see why an

underweight position still makes sense, speculative QE2 fervor

notwithstanding.

All we know is that in the aftermath of the very soft ISM and nonfarm payroll

reports for September, double-dip risks, as they pertain to the U.S. economy,

have not exactly disappeared. So it would stand to reason that an equity

investor would rather own sectors that have low as opposed to high

correlations with the U.S. economy. The sectors with the highest

correlations are industrials, financials and technology. The sectors with

the lowest correlations are health care, energy and utilities.

Whats even better is that the first group has an average dividend yield of1.2% while the latter is 3.5%. So not only does the latter group have lower

exposure to the uncertain U.S. business cycle, but it carries a 230 basis point

dividend yield premium. The latter group of more defensive sectors also has

an average earnings yield of 7% versus 5% for the former group of segments

more geared to the domestic economic backdrop.

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In the aftermath of the very

soft ISM and nonfarm payroll

reports for September,

double-dip risks, as they

pertain to the U.S. economy,

have not exactly

disappeared


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In our work, Energy and Health Care are among two of the most undervalued

equity sectors at the current time; Financials and Materials, two of the most

expensive.

As for the overall U.S. equity market, our propriety fair-value model moved

down to 1,050 in the past month from 1,070, with regard to the S&P 500.

The range is 1,000 to 1,120 so the index has moved above the top end of the

band. This suggests an overvaluation of around 10% the last time it was

this overvalued was late last year; the Shiller normalized P/E ratio is now

pointing towards a near-30% degree of overvaluation; a Tobin-Q model that

looks at replacement-historical costs indicates a 20% level of overvaluation.

In a nutshell, this market is no bargain at todays prices. What stood out in

the past month was that the stock market surged even as analysts cut their

EPS forecasts, generating P/E expansion, presumably on QE2 hopes.

With respect to the TSX, our fair-value estimate also declined, to 10,785 in

the past month even as the market melted up now about 16% overvalued

from where the market is trading today (range of 10,380 to 11,090). There

was a modest decline in earnings estimates, both trailing and forward. The

most undervalued sectors are a little different than in the U.S.A. staples,

Tech and Telecom; Materials, Utilities and Financials are the most expensive.

In terms of the fixed-income market, our work still finds corporate bonds to be

attractively priced, on average, with BB rated bonds still the most

undervalued slice. Our main model incorporates BBB-rated product and it

suggests that we would still have 80bps of spread tightening to go before

hitting fair-value levels. The high yield market is better priced than investment

grade right now that story has not changed.

The Canadian dollar is now 99 cents (U.S.) while our fair-value estimate is

stuck at 91.5 cents. The last time the loonie was this far overvalued was

back in the third quarter of 2008. No doubt it took an event (like a black

swan) to knock the loonie off its perch back then, but suffice it to say, it is

more vulnerable to downside surprises from here than it is susceptible to any

substantial upside potential. In other words, despite the positive momentum

and the good news Canada story, the risks for the Canadian dollar from here,

at least over the near-term, seem to be pretty one-sided.

Despite the positive

momentum and the goodnews Canada story, the

risks for the Canadian dollar

from here, at least over the

near-term, seem to be pretty

one-sided


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Gluskin Sheffat a Glance

Gluskin Sheff+ Associates Inc. is one of Canadas pre-eminent wealth management firms.Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to theprudent stewardship of our clients wealth through the delivery of strong, risk-adjustedinvestment returns together with the highest level of personalized client service.OVERVIEW

As of June30, 2010, the Firm managedassets of$5.5 billion.

Gluskin Sheff became a publicly tradedcorporation on the Toronto StockExchange (symbol: GS) in May2006 andremains54% owned by its senior

management and employees. We havepublic company accountability andgovernance with a private companycommitment to innovation and service.

Our investment interests are directlyaligned with those of our clients, asGluskin Sheffs management andemployees are collectively the largestclient of the Firms investment portfolios.

We offer a diverse platform of investmentstrategies (Canadian and U.S. equities,Alternative and Fixed Income) andinvestment styles (Value, Growth and

Income).1

The minimum investment required toestablish a client relationship with theFirm is $3 million for Canadian investorsand $5 million for U.S. & Internationalinvestors.

PERFORMANCE

$1 million invested in our Canadian ValuePortfolio in 1991 (its inception date)

would have grown to $10.9 million2

onJune30, 2010 versus $5.4 million for theS&P/TSX Total Return Index over the

same period.$1 million usd invested in our U.S.Equity Portfolio in 1986 (its inceptiondate) would have grown to $10.9 millionusd

2on June30, 2010 versus $8.6 million

usd for the S&P500Total Return Indexover the same period.

INVESTMENT STRATEGY & TEAM

We have strong and stable portfoliomanagement, research and client serviceteams. Aside from recent additions, ourPortfolio Managers have been with theFirm for a minimum of ten years and wehave attracted best in class talent at all

levels. Our performance results are thoseof the team in place.

Our investmentinterests are directlyaligned with those ofour clients, as Gluskin

Sheffs management andemployees arecollectively the largestclient of the Firmsinvestment portfolios.

We have a strong history of insightfulbottom-up security selection based onfundamental analysis.

For long equities, we look for companieswith a history of long-term growth andstability, a proven track record,shareholder-minded management and ashare price below our estimate of intrinsic

value. We look for the opposite inequities that we sell short.

$1 million invested in our

Canadian Value Portfolio

in 1991 (its inception

date) would have grown to

$10.9 million2 on June 30,

2010 versus $5.4 million

for the S&P/TSX Total

Return Index over the

same period.

For corporate bonds, we look for issuers

with a margin of safety for the paymentof interest and principal, and yields whichare attractive relative to the assessedcredit risks involved.

We assemble concentrated portfolios our top ten holdings typically representbetween 25% to 45% of a portfolio. In this

way, clients benefit from the ideas inwhich we have the highest conviction.

Our success has often been linked to ourlong history of investing in under-followedand under-appreciated small and mid capcompanies both in Canada and the U.S.

PORTFOLIO CONSTRUCTION

In terms of asset mix and portfolioconstruction, we offer a unique marriagebetween our bottom-up security-specificfundamental analysis and our top-downmacroeconomic view.

For further information,

please contact

[email protected]

Notes:

Page 7 of 8

Unless otherwise noted, all values are in Canadian dollars.1. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.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.


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