Breakfast With Dave 8/9/10

8/9/2019 Breakfast With Dave 8/9/10

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August 9, 2010 BREAKFAST WITH DAVE

The Birth-Death adjustment factor tacked in 16k jobs to the seasonallyadjusted data, so actually, that 12k number was probably more like

-4k. Doubly pathetic.

The Household survey showed a 159k loss, which was the third decline in arow something that in the past occurred outside of recessions a mere 2%

of the time. Full-time employment tanked 570k (on top of a 70k falloff in

June) which was the steepest decline since the depths of economic and

market despair in March 2009.

The Household Survey, on a population and payroll concept adjusted basis,posted a decline of 315k and this followed a 363k loss the month before.

If not for the near one million decline in the labour force since April thenumber of discouraged workers has ballooned 50% in the past year the

unemployment rate would be sitting at 10.4% right now (if the participation

rate was unchanged from Aprils level).

As a sign of how far the economy has slowed from its springtime peak, theemployment/population ratio dipped from 58.8% in April to 58.7% in May,

to 58.5% in June, to 58.4% in July the lowest it has been since the turn of

the year. Moreover, two-thirds of the private sector job creation this year

took place in March and April, when the economy was hitting its peak.

We had mentioned that one of the bright spots in the data was the pickupon factory payrolls, but again this was more the result of seasonal

adjustment wizardry than anything else. Somehow, a 16k drop in the

automotive industry in the raw data managed to swing to a +21k print on a

seasonally adjusted basis and this likely reflected the one-off lack of plant

idling this year at GM.

The workweek did edge up, but it is still an anaemic 34.2 hours and thisreflects the ability of businesses to adapt their labour force needs more

than anything else. The fact that they chose this route rather than add

bodies, and shedding full-time workers, is a sign that companies lack a

commitment right now. The fact that they cut their reliance on the temp

agency market for the first time in 10 months is another indication that the

aggregate demand for labour contracted last month.

At the rate the economy is creating jobs 654,000 so far this year wewill not get back to the previous peak in employment until 2017. Just to get

back to the 8% unemployment rate that the White House had forecasted we

would require job creation of at least 2.5 million. At the rate we are going,

that will take longer than two years to accomplish.

Lets not lose sight of the fact that initial jobless claims kicked off themonth of August by jumping 19k, to 479k, the highest level since last

August. If we see this number back up to over 500k, then for sure we will

see less denial over double-dip risks.

Page 3 of 12

When adjusted for the

Census worker effect, theU.S. economy only

generated 12k net new jobs

last month How pathetic

is that

At the rate the economy is

creating jobs; we will not

get back to the previous

peak in employment until

2017


4/12


TAKE MR. BOND VERY SERIOUSLY

The yield on the 10-year note hit its nearby peak on April 5, at 4.01%, and has

since plunged nearly 120 basis points.

Declines of this magnitude very often presage the onset of bear markets and

recessions. Typically, equities and then economists are late to the game. Nothing

we are seeing is any different from the past, at least on this score.

What is key to note is that the bond market is the tail that wags the stock

markets dog it leads.

The 10-year note yield peaked on May 2, 1990 at 9.09%. By December 12,

1990, the yield was all the way down to 7.91%. The S&P 500 peaked on July

16, 1990, the same month the recession started. So Mr. Bond led both by over

two months the 120 basis point slide in yields by December provided

ratification (though there were still some, including Alan Greenspan at the time,

who still believed a recession had been averted).

The yield on the 10-year T-note peaked at 6.79% on January 20, 2000 the

stock market peaked less than eight months later on September 1. By

November 28, 2000, the yield had plunged to 5.59% down 120 basis points

(as is the case today), again providing ratification that we were not heading into

some routine soft patch. Indeed, the recession started in March 2001, so the

bond market again played the role of the real leading economic indicator, not

the stock market.

Then in the most recent cycle, the 10-year T-note yield reached its high on June

12, 2007 at 5.26% by November 21, it was all the way down to 4.00%. The

S&P 500 peaked on October 9, 2007, three months after the peak in the bond

yield. Yet again, a 120 basis point slide was the smoking gun for the economic

downturn it was called the hard landing then, though the plethora of

economists decided to look the other way; and today it is called the double dip

and once again this view is met with widespread ridicule from the economics

intelligentsia.

DEFLATION NOW A MAINSTREAM VIEW?

We could go on and on about how early we were on the deflation call this was

central to our debate with Jim Grant at the Grants conference back in April when

deflation was considered by many to be a controversial and completely out-of-

the-mainstream view. Not to mention that back then the yield on the 10-year

note was nearly 4% and a growing chorus of economists were calling for 5%+.

The economy and the stock market were so hot by then that the Fed was on the

precipice of shrinking its balance sheet, everyone was debating when the first

tightening was going to come and the White House was busy gloating about the

success of the fiscal boosts (to the point where Larry Summers boasted that

the economy appears to be moving towards escape velocity two weeks

before the stock market peaked). Talk about the proverbial kiss of death.

Page 4 of 12

Lets not forget, the bond

market is the tail that wagsthe stock markets dog it

leads


5/12


The yield on the 2-year note is at a record low of 0.5% down 5bps last week

and the 10-year note is at a 15-month low of 2.82% after last weeks 9bp rally.

We had said for some time that while it was a financial panic that led to the

downdraft in yields back to these levels in late 2008 and early 2009, the next

time we revisit these levels in the near future it would be an economic event

as opposed to a financial event. And, here we are (note, this huge bond rally

has taken place even with the U.S. dollar sinking to a 15-year low against the

Japanese yen so much for a weaker greenback triggering higher yields).

Look at what the bond market is doing for the economy; it is driving mortgage

rates down to new all-time lows of 4.5%. The rally in Treasuries, which for some

reason so many market pundits resist, has also played a crucial role in

revitalizing the corporate financial backdrop. The 100 basis point decline in

AAA-rated company bonds in the past 12 months, to a 40-year low of 4.72%,

didnt happen all on its own. The downdraft in government bond yields a

welcome downdraft has played a vital part in dramatically cutting into debt-

service expense across the business sector. The yield on the 5-year TIPS is

close to zero, which is another indication that inflation concerns right now have

been completely swept under the rug. Globally, we also saw the 10-year JGB

yield dip below 1% while the German bund retreated 16 bps back to 2.5%.

And, over the weekend, the same media types that four months ago were

lamenting over inflation are now fil led with deflation commentary check out

these articles from the weekend press:

Time to Print, Print, Print (page 15 of Barrons)A Lover of Treasurys Bets on Deflation (page B1 of the weekend WSJ)

How to Beat Deflation (page B7 of the weekend WSJ)Japanese-style Inflation Fears Bode Well for U.S. Bonds (page 15 of the

weekend FT)

Afraid of Deflation? Try Some Medicine (Page 6 of the Sunday NYT businesssection)

Fed Must Beware of Publics Deflationary Mindset (page C1 of MondaysWall Street Journal)

As contrarians, we much preferred it when the crowd was still crowing about

inflation and there was dearth of deflation talk. Now it has become

commonplace and that indeed has us concerned that much of the deflation view

is priced in to the market (consider that the Fed funds futures contract has

pushed out the date of the expected first Fed tightening to August of next year).

We are not yet prepared to abandon our long-standing deflation views but we

are nervous that this is now becoming a mainstream forecast and lets face it,

yields across the Treasury curve have rallied to levels that virtually nobody saw

coming this year.

Page 5 of 12

Look at what the bond

market is doing for theeconomy; it is driving

mortgage rates and AAA-

rated corporate bonds down


6/12


When you look at the variety of top 10 surprise lists that were published at the

start of 2010, who was saying back then that the best-returning security would

be the 30-year zero coupon bond? Were there any strategists back then

forecasting that heading into the eighth month of the year that bonds would be

outperforming stocks?

Then again, if there is a part of the curve that has lagged behind, not yet hit new

lows in yield, and that represents true inflation expectations, it is the long bond

at 4.00%. There is probably more juice here than anywhere else along the

maturity spectrum if the economy continues to weaken and along with that, the

forces of deflation gather steam. As an aside, it was interesting to see gold

trade back up to a three-week high of $1,200/oz even as the CRB index closed

the week with a 1.1% loss (biggest decline since June 29). This goes to show

that it is also an effective hedge against deflation (as was the case in the 1930s

when the sterling price of gold doubled).

Moreover, we can take solace in the widespread acclaim that Jan Hatzius at

Goldman Sachs is now receiving for being the prominent pessimist on Wall

Street. The front section of the Saturday NYT (page A3) says: A prominent

pessimist, chief economist for Goldman Sachs, lowered his forecast of

economic growth for 2011 to 1.9%, from 2.5%.

What a country! You are labelled a prominent pessimist with a 1.9% growth

forecast. This guy would be a hero through much of Europe not to mention

Japan. In the U.S.A., he is labelled a pessimist. Well, having worked on Wall

Street for close to seven years and having been early on the 2008-09 recession

call, we know what being pessimistic (more like realistic, but who knew back

then when securitization was a license to print money) is all about. So, we take

some solace at least that even though there is talk now about deflation, it

really has not comprised anyones official forecast, and that double dip risks

continue to be readily dismissed.

When Jan Hatzius, who by the way is a first-rate economist, cuts that 1.9% to

something closer to 0% for 2011 GDP growth, we will know that the degree of

pessimism has reached its climax. In our view, what the NYT dubs a

pessimistic growth forecast is really the best-case scenario for the economy in

the coming year.

To be sure, there is growing chatter that the Fed is once again going to come to

the rescue and Barrons hints strongly at a coming $2 trillion quantitative easing

program. The rumour mill is filled with talk of how the Administration is cookingup a new scheme, through the channels of Fannie and Freddie, to forgive part of

the mortgage loans for distressed homeowners who are upside down ( ie,

negative net equity in their home) a huge fiscal expansion that could bypass

Congressional approval.

Atlanta Fed President Lockhart summed it all up in a sermon he delivered back

on June 30:

Page 6 of 12

If there is a part of the curve

that has lagged behind, notyet hit new lows in yield, and

that represents true inflation

expectations, it is the long

bond

To be sure, there is growing

chatter that the Fed is once

again going to come to the

rescue


7/12


To sum up, I don't see inflation as much of a current worry. If anything, there is

a small risk of deflation that must be monitored. Limited inflation allows focused

attention to recovery and growth, which I'd like to turn to now.

Heres a key point about these contributors to recovery each could be

transitory. The economy has not yet arrived at a state where healthy and

sustainable final demand is underpinning growth.

I make this point not to predict a reversal of the progress made but just as a

cautionary reminder to avoid counting chickens too early. There are sectors

that remain in a very depressed condition housing, for example.

So, to pull this together, a recovery of the national economy is proceeding but

not yet with solid and sustainable underpinnings. Inflation appears restrained.

The outlook from here is beset by somewhat more than normal uncertainty.

These are very disturbing conclusions. Twice he mentions the fact that without

policy stimulus, there are no sustainable underpinnings to the fragile economic

recovery. No wonder the Nation Bureau of Economic Research (NBER) has yet

to declare the downturn to be over if the private sector requires stimulation

from the public sector, then the economy must still be in a recessionary

state. Its no different than taking some aspirin to break the fever, but you only

know if you are no longer sick when your temperature is normal when you are off

the medication. Mr. Lockhart goes much further and intimates that not only is

public policy needed to stimulate economic activity, but that it is required to

sustain growth.

Friends, when the private sector needs the public sector for growth to be

sustained not just stimulated, which is par for the course in fighting

recessions in a classic post-war Keynesian fashion then you know that we

actually have on our hands is a depression. Lets not keep our head in the sand

and stay in denial mode. When you have a Federal Reserve official lamenting

about how the economy still to this date has no sustainable underpinnings

after the central bank has taken rates to zero, tripled the size of its balance

sheet and the government has bailed out banks and homeowners and

embarked on an array of spending incentives that has taken the deficit to a

record 10% of GDP (outside of WWII) then you know that we have a totally

different experience on our hands.

Nearly half of the 14.6 million unemployed have been out of work for over six

months (according to the NYT,a level not seen since the Depression

); and 1.4

million have been jobless for more than 99 weeks, at which point jobless

benefits run out. Professor Robert Gordon, one of the gurus at the NBER, told

the NYT that [t]he situation is devastating. We are legitimately beginning to

draw analogies to the Great Depression, in the sense that there is a growing

hopelessness among job seekers.

Page 7 of 12

In the U.S., if the private

sector requires stimulationfrom the public sector, then

the economy must still be in

a recessionary state


8/12


In this light, maybe the fact that there is some growing acknowledgment of

deflation risks and that a cut to a GDP growth forecast by a prominent

pessimist to +1.9% is perhaps just the beginning stage of acceptance as

opposed to our view being totally priced in at the current time. Though after

readingWelcome to the Recoveryon the op-ed page of last Tuesdays NYT by

Timothy Geithner, there does seem to be denial at the highest level of

policymaking in Washington (Frank Rich in his excellent op-ed piece in the

Sunday NYT rather appropriately called Mr. Geithner tragically tone-deaf).

Meanwhile, in the same edition we saw Alan Greenspan state that the economy

was in a quasi recession hopefully Mr. Geithner realizes that President

Obamas approval rating is down to a record low of 41% and its not about how

he is handling the war on terror as much as to what is happening to the labour

market.

As for policy prescriptions, maybe its time to abandon all the fiscal quick fixes

that have little multiplier impact at tremendous taxpayer cost. With 6.6 million

unemployed now for at least six months and discouraged workers dropping out

of the labour market at an alarming rate, perhaps we need more in the way of

creative supply-side measures to bolster business investment and durable

employment growth. For more on this file, have a look at the column on op-ed of

the Saturday NYT (The Economy Needs a Bit of Ingenuity page A15).

And Bill Gross couldnt have put it any better either to the Sunday NYT. To wit:

In the new-normal world, there are structural problems, which require

structural solutions.

A WEAK CONSUMER OUTLOOK

It looks like July was another soft month even with the incentive- and fleet-led

rebound in auto sales (that still left them below consensus expectations, by the

way). Call it deflationary growth but auto incentives were up an average of 2.5%

YoY in July (according to Edmunds.com).

Moreover, almost 70% of retailers missed their sales targets last month, and

July was the fourth month in a row in which sales came in below plan (+2.9%

versus +3.1% expected last month). Keep in mind that the +2.9% YoY trend is

being flattered by the depressed base in the comparable year-ago period when

sales plunged 5.1% in July 2009. And, we see from the RBC outlook survey that

62% of families are either going to cut their back-to-school budgets this year or

actually spend nothing at all. Another 29% intend to spend the same while only

9% of the respondents indicated a willingness to loosen their purse strings andspend more than they did in 2009.

At least the ECRI weekly leading index improved last week, to -10.3 from -10.7,

but the damage has already been done and recession risks based on this index

hovers around 2-in-3 odds.

Page 8 of 12

Maybe its time to abandon

all the fiscal quick fixes thathave little multiplier impact

at tremendous taxpayer

cost

It looks like July was

another soft month even

with the incentive- and fleet-

led rebound in auto sales in

the U.S.


9/12


What seems obvious is that left to its own devices, households are concentrating

on boosting savings (that was loud and clear in the Q2 GDP data) and paying down

debt while Junes $1.3 billion net reduction in consumer credit was light vis--vis

expectations, credit card debt was pared by $4.5 billion, which was the 21st

consecutive decline.

GREENSPAN WEIGHS IN ON TAXES

One of the sources of uncertainty out there is the tax picture for 2010 this is

now turning into a heated debate, even among Democrats. So far, Geithner is

not biting. And, it would seem as though he and the White House received a

shot in the arm from Alan Greenspan who was quoted in the Saturday NYT (see

Greenspan Calls for Repeal of All the Bush Tax Cuts on page B1) as saying: Im

in favor of tax cuts, but not with borrowed money. He added that while the

repeal is risky as far as affecting the economy, he stressed that the choice of

not doing it is far riskier. It is the difference between bad and worse ...

A NICE RUN FOR THE COMMODITY COMPLEX

After taking a dive during the depths of the European debt mess in the spring

and early summer, we have seen the likes of oil, copper, zinc, tin and nickel all

soar to multi-month highs. This has occurred even with the pace of U.S.

economic activity sputtering, and has partly reflected confidence that Chinese

growth will remain close to double-digits and that most of the policy tightening

there is now behind us.

Recall that back in 2008, the commodity complex rolled over eight months after

the U.S. recession began the problem for the oils and metals was when the

financial crisis morphed into a Chinese economic downturn. This is what we

have to keep an eye on, and the one metric that has us a bit concerned is thenews that Chinas PMI dropped to a 17-month low in July (to a sub-50

contractionary reading of 49.4 we may add down from 50.4 in June and the

fourth decline in as many months).

PROFIT UPDATE

What do you know? Of the 443 companies that have reported thus far, 75%

have beaten their forecasts. That number changes about as often as double-

digit GDP growth does in China.

Overall operating EPS is on track to show a 38% YoY gain (+46% on a reported

basis) well above the 27% that the consensus was expecting when Q2

earnings season began. But the market now needs top-line performance too,

especially with profit margins back to cycle highs and 38% of companies havedisappointed on this score (Revenue at Viacom Remains the Same, but Profit

Rises on Cost-Cuttingas per page B4 of the NYT).

Page 9 of 12

After taking a dive during

the depths of the Europeandebt mess in the spring and

early summer, we have seen

the likes of oil, copper, zinc,

tin and nickel all soar to

multi-month highs


10/12


Page 10 of 12

Sales in Q2 are running at just +5.5% YoY or basically 1/7th the pace of overall

profit. The consensus for 2010 operating EPS is around $96 with margins hitting

fresh highs revenues are seen rising 6.3% in 2011, which would imply a pace

that is at least double nominal GDP growth (they both tend to rise in tandem);

though profit growth of 16% would be more than five times stronger than nominal

GDP growth, which points to profit margins hitting cycle highs highs that in the

past coincided with booming economic growth years. Margins tend to be mean-

reverting and as the FT points out, if we were to apply a 3% nominal GDP growth

estimate for next year with profit margins heading back to the long-run norm, we

would be talking about corporate earnings coming in closer to $71 per share. This

then means that we are possibly talking about a forward P/E multiple of 16x as

opposed to the cheap 11.5x that everyone bandies about just because it is the

consensus view the same consensus that typically overstates earnings by an

average of 20% at turning points in the economy.

Also keep in mind that consensus reported EPS forecasts for next year have

been marked down to $75.50 from around $77. In the 1980s, and much of the

1990s, outside really of that financial debacle in 1992, operating and

reported EPS tracked each other quite closely. It was really 1997 and onward

that Wall Street began to advertise operating earnings as the profit measure to

focus on you know, the earnings measure that excludes mistakes (because

ostensibly they are one offs). But as our old pal Rich Bernstein pointed out

time and again, it is reported earnings the tried, tested and true GAAP

results that investors should be paying for, not the earnings that smoothes

over the bad stuff. So even here, supposedly heading into the third year of a

recovery, the consensus has a $20 EPS gap between these two series, which is

unusual. But if we are going to deploy as reported earnings, then even using

the consensus view we get a 15x forward multiple. That may not be exorbitant,but it is still overpaying for whatever expansion we are likely going to see from

the income statement through the end of 2011.

INCOME THEME INTACT

To the frustration of many a bull, we are sure, Main Street investors continue to

ignore Wall Street strategists by shunning the ever-volatile equity market for

safety and income at a reasonable price. The ICI data just came out for the July

28th week and showed a net outflow of $3.9 billion dollars from equity funds

while bond funds attracted $7.1 billion of fresh money on top of $7.9 billion the

week before. Hybrid funds, which also deliver an income stream, posted net

inflows of $69 million too, in addition to $370 million the previous week. As an

aside, remember how everyone always laments about how America has lost

control of its bond market because over half of outstanding Treasuries areowned by foreign investors. Well, a new page has been turned in this story

because U.S. residents, in their deliberate attempt to add income-generating

securities to their asset mix, now comprise 50.2% of the Treasury market up

from 44.3% two years ago. This demographic drive for income is increasingly

emerging as a secular theme as households move to correct their dramatic

under-exposure to the fixed-income market (remember, the first of the 78 million

boomer population hits retirement age this year).

To the frustration of many a

bull, we are sure, MainStreet investors continue to

ignore Wall Street

strategists by shunning the

ever-volatile equity market

for safety and income at a

reasonable price


11/12


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

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$1 million invested in our

Canadian Value Portfolio

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date) would have grown to

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Notes:

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Unless otherwise noted, all values are in Canadian dollars.

1. Preliminary unaudited estimate.2. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.3. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses.


12/12


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any such proceedings have not been reviewed by, discussed with, and maynot reflect information known to, professionals in other business areas ofGluskin Sheff in connection with the legal proceedings or matters relevant

to such proceedings.

Any information relating to the tax status of financial instruments discussedherein is not intended to provide tax advice or to be used by anyone toprovide tax advice. Investors are urged to seek tax advice based on theirparticular circumstances from an independent tax professional.

The information herein (other than disclosure information relating to GluskinSheff and its affiliates) was obtained from various sources and GluskinSheff does not guarantee its accuracy. This report may contain links to

third-party websites. Gluskin Sheff is not responsible for the content of anythird-party website or any linked content contained in a third-party website.Content contained on such third-party websites is not part of this report andis not incorporated by reference into this report. The inclusion of a link in

this report does not imply any endorsement by or any affiliation with GluskinSheff.

All opinions, projections and estimates constitute the judgment of theauthor as of the date of the report and are subject to change without notice.Prices also are subject to change without notice. Gluskin Sheff is under noobligation to update this report and readers should therefore assume thatGluskin Sheff will not update any fact, circumstance or opinion contained in

this report.

Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheffaccepts any liability whatsoever for any direct, indirect or consequentialdamages or losses arising from any use of this report or its contents.

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Breakfast With Dave 8/9/10

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Transcript of Breakfast With Dave 8/9/10