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Transcript of Lunch With Dave 032910
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David A. Rosenberg March 29, 2010Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919
MARKET MUSINGS & DATA DECIPHERING
Lunch with DavePLEASE NOTE THAT WE WILL NOT BE PUBLISHING IN THE NEXT TWO DAYS.
THE NEXT PUBLICATION DATE IS THURSDAY, APRIL 1
Show me the money!
Who will buy U.S. bonds?Sentiment is so negativeon the U.S. Treasurymarket its not even funnyanymore
U.S. savings rate slidespurs spending
Why Canadiancommercial real estate isstill so firm
U.S. earnings update bottom-up analysts areexpecting another goodquarter of earnings in Q1
My take on the U.S. Q4GDP report
Whats on the worry list?April is a key month, nofooling
Market thoughts I knowwhat a broken recordsounds like and this hasbeen a confounding andconfusing market forboth the bears and many(though not all) of thebulls
IN THIS ISSUE
MARKET THOUGHTS
Well, well, the theory that the stock market has turned in a double top may not
have gone the way of the Dodo after all, following the reversals we saw in the
last two trading days of last week. Negative reversals and distribution days in
three of the last six sessions is something to be concerned about if you are long
this market and volume remains tepid at best.
The market is now overvalued by over 25% but is also extremely overbought
having gone 24 sessions without a decline of 1% or more, and 89% of the stocks
in the S&P 500 are now trading above their 50-day moving averages (see page
M3 of Barrons). The Dow has advanced in 17 of the past 21 days. I mean,
even if you are bullish on the outlook, one would have to admit that such a
parabolic move is vulnerable to at least a modest pullback or more. I know
what a broken record sounds like and this has been a confounding and
confusing market for both the bears and many (though not all) of the bulls.
Looking at the fund flows, there is only one conclusion that can be reached: This
market is being driven by pig farmers. Retail inflows may have picked up of late,
but only fractionally. The focus on the part of the individual investor remains on
the fixed-income market, for better or for worse (better from our standpoint,worse from the standpoint of my friend and fellow debater Jim Grant).
Institutional portfolio manager cash ratios are back to the rock bottom levels of
around 3% where they were back at the market peak in October 2007. The
shorts have all but been covered. Foreign investors have been few and far
between, based on the latest TICS data. The lack of volume speaks volumes
there are no sellers. Investors of all types have been content to just sit and
watch their equity position expand via the price appreciation, but there is scant
evidence of any follow-through this year in terms of volume buying.
So, that leaves me with a suspicion that the entities doing the buying are the pig
farmers. Who are they pray tell? They are the prop desks at the five large
banks. They buy and sell securities, with leverage ... to each other! And, thesetransactions often occur late in the day or in the futures pit after the market
closes. There is no sign of any other buyer out there, including the Fed who has
been too busy choking on mortgage backed securities and Maiden Lane assets.
To repeat, that is why the volumes have been so low.
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
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What we should be aware of about the pig farmers is that they could, at any
time, flick the switch in the other direction. What the trapped longs may be
forced to do the ones that have been sitting on their hands and have been
waiting for the bear market rally to take their portfolio back to where it was at
the peaks at that point is start to sell. That is when the volume picks up ...
and accelerates the downside pressure.
It is always difficult to
predict the future, but somany investors are
caught in the moment
Of course, it is always difficult to predict the future, but so many investors are
caught in the moment and are being told not to fight the tape and simply play
the momentum game. They do not see that the current rebound in the economy
is a statistical mirage orchestrated by record amounts of monetary and fiscal
stimulus that are simply unsustainable and actually risk precipitating a very
unstable financial and economic backdrop in coming years.
From our lens, the rally of the last 12 months smacks of the 1930 snapback,
and if memory serves us correctly, the S&P 500 went on to hit new lows in
subsequent years and the next secular bull market did not start until 1954. I
am sure that all the bullish pundits and tape watchers were ridiculing the
cautious folks back then just go and have a look at the Diary of Benjamin Roth
and you will see how much giddiness there was over the bear market rally and
that the worst was over back then. Meanwhile, the lows were still more than a
year away to everyones surprise except those who kept their eyes on the
forest, not the trees.
Deleveraging cycles take years to play out, even with massive doses of
government intervention.
In todays context, once again few, if any, will know when we reach the peak
since there is no perfect market-timer out there that we know of. But the
pattern of the past 12 years, when Alan Greenspan embarked on the bailout
path with LTCM back in 1998, and the roller-coaster ride that ensued since, it
has been just as prudent to take profits after a 70% bounce as it would have
been to start adding to equity positions after a 50% decline.
It is clear from the volumes of emails I receive daily that there is frustration
among those who think they have somehow missed something important by not
being overweight cyclical stocks over the past year. The tone of the responses
to my daily musings is eerily similar to the complaints I saw frequently back in
2006 and 2007 and the advice not to fight the tape or to fight the Fed.
These are just glib after-the-fact excuses for going long the market when nobody
really has a good idea on why we should be bullish in the first place.
We hate to break it to the bulls but even with the pleasant rally in risk assets
over the past year, there really is nothing to be bullish about when it comes to
how the economy is performing now or in the future as all the monetary and
fiscal largesse is unwound. Have a look at States Look to Tax Services, From
Head to Toe on the front page of the Sunday NYT, as well as Moves to Tax Banks
to Pay for Bailouts Gain Steam on page C1 of todays WSJ.
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As an aside, if the Administration does not enact a new tax law, the tax rate on
dividends reverts to the pre-2001 rates, which are the same as rates on ordinary
income 39.60% at the top bracket. Recall that by the time the 1930s came to
an end, FDR paid for the massive fiscal expansion by lifting top marginal tax
rates, to 80%.
What we have to
constantly remindourselves is that we are
still in a secular bear
market
What we have to constantly remind ourselves is that we are still in a secular
bear market, that the S&P 500, through all the numerous peaks and valleys, is
still in the hole to the tune of 25% over the past decade, that we are in the
classic Bob Farrell stage 2 of the long cycle, which is the reflexive rebound
phase, and that frankly, there is really no reason to add undue risk to the
portfolio except perhaps for the most ardent day-trader.
Its remarkable how so many people still refuse to accept what history has
taught us about post-bubble credit collapses they do indeed require ongoing
government support, but even then we endure five to seven years of economic
stagnation. And, that flat line will involve periods of growth followed by periods
of contraction but the lasting theme is one of volatility.
For a long while, I have recommended that investors have a read of The Great
Depression: A Diary. It is the story of Benjamin Roth (a Youngstown lawyer) the
only detailed personal account of the 1930s that has been published. On July 31,
1931, he entered this into his journal: Magazines and newspapers are full of
articles telling people to buy stocks, real estate etc. at bargain prices. Of course,
this was right during the reflexive rebound and the market still had 35% to go on
the downside before the triple waterfall bear market was complete.
On March 6, 1933, he lamented that When I started in 1930 to jot down the
happenings during the depression I had no idea it would last as long and I did
not think I would require more than one small notebook. Now after 3 years of
the worst depression has even seen, the end is not in sight.
Through all the
numerous peaks and
valleys in the market,
the S&P 500 is still in
the hole to the tune of
25% over the past
decade
It is very important not to get caught up in the euphoria in the business media
and the mania in the financial markets. The most dangerous thing anyone can
do right now is extrapolate the stimulus-led bounce of the past year into the
future. As Mr. Roths diary shows, these post-bubble bouts of giddiness were
not sustained, even with the New Deal.
As was the case back then, the investors who end up succeeding are not the
ones who are able to play the flashy bear market rallies but the ones who opt for
strategies that minimize volatility and optimize risk-adjusted returns. Income,whether it be from paper assets (bonds, dividends) or hard assets (oil and gas
royalties, REITs), is going to emerge as king in an environment where the primary
trend is one of deflation, which is indeed the case as private sector credit
contracts.
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The U.S. dollar has been strengthening, gold is sputtering, rents are declining,
wages decelerating, core consumer prices flattening and now money supply
growth is vanishing. It may take the equity market time to absorb all of this, but
for those who believe that at some point the economic fundamentals will come
to dominate the landscape, it may pay to gaze at the charts below that depict
the current economic cycle relative to the average of its predecessors. These
charts show everything from real GDP, to real final sales, to employment, to
industrial production, to retail sales, to housing and it is plain to see that this
goes down as the weakest post-recession recovery on record despite the fact
that it is being underpinned by the most intense level of government support on
record. That indeed is cause for pause.
CHART 1: NOT YOUR TYPICAL RECOVERY REAL GDP
United States
(data indexed to 100 = start of recession)
95
96
97
98
99
100
101
102
103
104
105
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Number of Months from the Start of Recession
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
CHART 2: NOT YOUR TYPICAL RECOVERY FINAL DOMESTIC SALES
United States: Real Final Domestic Sales
(data indexed to 100 = start of recession)
97
98
99
100
101
102
103
104
105
106
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 2
Number o f Months f rom the S tar t o f Recess ion
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
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CHART 3: NOT YOUR TYPICAL RECOVERY EMPLOYMENT
United States: Nonfarm Payrolls(data indexed to 100 = start of recession)
93
94
95
96
97
98
99
100
101
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Number of Months from the Start of Recession
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
CHART 4: NOT YOUR TYPICAL RECOVERY INDUSTRIAL PRODUCTION
United States: Industrial Production
(data indexed to 100 = start of recession)
85
87
89
91
93
95
97
99
101
103
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Number of Months from the Start of Recession
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
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CHART 5: NOT YOUR TYPICAL RECOVERY RETAIL SALES
United States
(data indexed to 100 = start of recession)
88
90
92
94
96
98
100
102
104
106
108
110
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Number of Months from the Start of Recession
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
CHART 6: NOT YOUR TYPICAL RECOVERY HOUSING STARTS
United States
(data indexed to 100 = start of recession)
40
50
60
70
80
90
100
110
120
130
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Number of Months from the Start of Recession
Represent average length of a recession
Expansion Phase
Recession
End of Current Recession
Source: Haver Analytics, Gluskin Sheff
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WHATS ON THE WORRY LIST?
April is a key month, no fooling:
April will be a key month
no fooling
Last weeks bond auctions did not go well. It seems that Japan and China didnot show much interest. The lack of bids was no better underscored than in
the 7-year Treasury note auction where the median yield was 3.29% versus
3.05% a month earlier. April is a cruel month for the U.S. Treasury market,
with 10-year yields rising in each of the past 4 Aprils and in 6 of the past 7,
and by an average of 25 basis points. (As Alan Greenspan said on Bloomberg
News last week, higher yields are the canary in the mine.)
That, in turn, could spook the equity market since another 25bps of upsidepressure could then generate a fund-flow spiral as was the case in the
summer of 2007 3.85% (where we are now) ostensibly is a trigger point for
selling of mortgage bonds. As rates rise, homeowners are less likely to pay
their mortgages early, which extends the life of the mortgage and that in turnencourages mortgage investors to neutralize the duration of their portfolios by
selling T-bonds and notes. We have seen this happen before and while it will
likely provide a nice buying opportunity given the deflationary headwinds the
economy now faces, the prospect of a spasm in the Treasury market is worth
considering. Every equity market correction in the past 1987, 1994, 1998,
2000, and 2007 was preceded by what turned out to be a brief but
significant runup in yields. See Stock Rally at Mercy of Rising Rates on page
C1 of todays WSJ). And, the more overvalued the equity market is, the more
the downside risks if bonds begin to provide greater yield competition in the
near-term. Jeffery Hirsch over at the Stock Traders Almanac is in todays NYT
predicting a 20-30% correction ahead (see Stocks Soar, But Many Ask Whyon
page B1) he notes the modest number of stocks hitting new 52-week highs
with every new interim peak being reached by the overall market.
The leading indicators are all pointing to a slowdown, and this could show up ina critical data-release week in mid-April with retail sales on the 14th, industrial
production on the 15th, and housing starts, as well as consumer sentiment, on
the 16th. The broad money supply measures are contracting again as the Fed is
no longer boosting its balance sheet at a time when both the money multiplier
and money velocity are showing no signs of turning higher.
Greece will be put to the test in April when 15 billion of bonds have to berolled over (through the end of May).
The Fed ceases to buy mortgage securities on Wednesday and this ishappening at a time when mortgage rates have already climbed back above
5% and the housing market is showing signs of rolling over again. See Spikein Treasury Yields Jolts Mortgages on page C2 of todays WSJ. There is also
pressure from within the Fed (Plosser the latest) to soon begin to sell
securities outright. One thing that is very likely on its way again is another
50bps hike on the discount rate has anyone noticed the TED spread
beginning to widen ahead of this? The banks, going forward, will not have
easy access to the window and will have to rely on each other for funding.
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April 15 looms as a critical day from a geopolitical standpoint. It is the day thatthe Treasury Department will issue its report concluding whether or not China is
a currency manipulator. If it is viewed as such then trade sanctions are likely to
ensue and very likely some bilateral tensions. This could be very good news for
the bullion market (as well as the Bloomberg News report today stating that gold
imports in India are surging right now up six-fold from a year ago as there
are an expected 1 million marriages planned for April and May).
Sentiment is so negative
on the U.S. Treasurymarket its not even
funny. Everyone seems
to focus strictly on
supply without realizing
that the only way to
predict a price is by
forecasting both supply
and demand
Speaking of geopolitical risks, President Obama has allowed U.S. relations withIsrael to deteriorate to such an extent, and is handling the Iran nuclear situation
with such a kid-gloves approach, that disturbing columns like this are now
popping up in newspapers like the NYT (Rift Exposes Larger Split In Views On
Mideast page A4), the National Post (Iran Preparing to Build Two More Secret
Nuclear Sites in Mountains, Experts Say page A8), and the WSJ (How the Next
Middle East War Could Start page A23). Even the prospect is enough to
underpin the energy stocks, which are currently priced for $69/bbl on WTI.
WHO WILL BUY U.S. BONDS?
Sentiment is so negative on the U.S. Treasury market its not even funny.
Everyone seems to focus strictly on supply without realizing that the only way to
predict a price is by forecasting both supply and demand. On its own, supply looks
worrisome given the Administrations bent on running huge fiscal deficits (and it
just unveiled a new set of initiatives to reverse the foreclosure crisis).
What is ignored in so much analysis is the demand side of the equation boomer
households, for example, have only 6% of their assets in bonds versus nearly 30%
in real estate and equities. They have about $8 trillion that they can put to use
towards income-oriented portfolio strategies and in fact this powerful demographic
trend is already underway. The banking sector is sitting on $1.3 trillion in cash
and if it ever decided to play the yield curve, as it did coming out of the credit
crunch of the early 1990s, it too could provide up to a trillion dollars of support for
the bond market (even if Bill Gross sits on the sidelines).
Finally, it may pay to have a look at what is happening at the State and local
government level when it comes to unfunded pension liabilities and the
modifications that are coming from the General Accounting Standards Board
(GASB). The era of relying on 8% return assumptions are no longer tenable in
a world of sub-4% nominal GDP growth. Looking at the latest Fed Flow of
Funds report, State and local government pension funds are sitting on an
equity allocation of nearly 60%, but only have 6.5% of their financial assets in
treasury, notes and bonds.
From the mid-1960s up until the mid-1990s, the bond share was consistently
between 20-30% and moving back into this range would involve roughly $500
billion of an allocation shift towards the fixed income market. I highly urge
everyone to read the article on page A2 of todays WSJ titled Showing the
Woes in Public Pensions.
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Ignoring the demand for fixed income product would have left you with a
dramatically incorrect forecast of where JGB yields were headed in the
aftermath of its credit collapse two-decades ago. There were at least seven
spasms to the upside, but the primary trend in bond yields was down.
Run-down in the U.S.
savings rate funded the
0.3% consumer
spending rate in
FebruarySAVINGS RATE SLIDE SPURS SPENDING
U.S. consumer spending rose an as-expected 0.3% MoM in February, even
though there was no growth in disposable income. So, the gain was funded by
a rundown in the savings rate, which went from 3.4% in January to 3.1% just
as the +0.4% print in January was underpinned by a drop in the savings rate
from 4.0% to 3.4%. At 3.1%, the savings rate is all the way back to levels last
seen in October 2008. At play seems to be the effects of lower gasoline prices
during the month as well as the prospect that the wave of strategic defaults
has left consumers with enough cash flow to propel consumption at a 1%
annual rate on its own.
Based on what is built in already, it looks as through real consumer spending
is on track for a near 3% annualized gain in Q1, which would be double what
we saw in Q4 of last year. But there are an array of offsets, from sharply
slower capex growth, depressed commercial construction and the renewed
turndown in the housing market. It looks like the economy will eke out
something close to a 2% annual rate this quarter as this still goes down as
one of the weakest post-recession recoveries in real final sales ever recorded
despite all of the fiscal and monetary stimulus in the system.
If you do the math, it is fascinating (and disturbing) to see that if not for the
rundown in the savings rate, consumer spending would have been negative in
both January and February and the build in for Q1 would be -0.6% annualrate (as opposed to +3%).
It would be more encouraging if the spending data were being funded by
organic income growth, but that is not happening at least not yet. Despite
the so-called improvement in labour market conditions in February, wages and
salaries were flat, and outside of government support, fell 0.2% for the second
month in a row. Real personal income excluding government transfers is one
of the four main components that comprise the NBERs formula for
determining whether the economy is in recession or expansion and it covers
about two-thirds of the economy it remains squarely in recession terrain.
The savings rate was 6.4% last May and running this down by half has
certainly given the household sector some leeway to continue to spend as hasbeen the case. But with fiscal and monetary support in the process of
subsiding, even with the improvement in the jobs market, the lack of income
growth and the depleted savings rate point to a subdued spending pattern
ahead. This was confirmed by the recent downleg in the UofM consumer
expectations survey, which is down to a four-month low and is foreshadowing
a 1.0-1.5% consumption trend in the next two quarters.
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The bond market is obviously going to be a possible headwind for equities if the
backup in yields persists. Much of the spasm is technical in nature there is
certainly nothing to be concerned about with regard to the inflation background,
and it is inflation that ultimately drives the trend in bond yields, not fiscal policy.
Not only have wages stagnated in two of the past three months, but the PCE
deflator, both the headline and the core (which excludes food and energy), came
in flat in February. While the CPI is maligned for having too strong a weighting in
housing, the PCE deflator does not share this problem and the core index is
now running at a mere 1% annual rate over the past three months down from
the 1.5% trend at the end of 2009.
The Commerce Department also publishes a market based PCE number, which
excludes prices that the government imputes. On this score, underlying
inflation has been falling even faster +0.3% at annual rate over the past three
months and at +1.2% YoY, it is now at the slowest pace since September 2003
when the unemployment rate was around 6%, not 10%.
CHART 7: LOOK WHERE UNDERLYING INFLATION IS HEADING
United States: Market Based PCE: Excluding Food & Energy
(year-over-year percent change)
05050
5.25
4.50
3.75
3.00
2.25
1.50
0.75
Source: Haver Analytics, Gluskin Sheff
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WHY CANADIAN COMMERCIAL REAL ESTATE IS STILL SO FIRM
We are not talking about residential real estate, which is in some form of a
bubble, especially in Toronto and Vancouver. But anecdotally, commercial
real estate is holding in very well and one of the reasons could well be foreign
expansion into Canada.
In Canada, thecommercial real estate
market is holding in very
well compared to the
residential sector, which
is in some form of a
bubble
For a sign of what is happening in the retail sector, as one example, have a
read of the article on page B4 of todays WSJ (U.S. Apparel Retailers Map an
Expansion to the North). What does Canada offer to American companies who
want to grow but cannot do it without moving aggressively to gain market
share in an oversaturated U.S. backdrop? Well, as the article asserts, Canada
offers a way to expand internationally but in a market thats closer and more
familiar than Europe or Asia.
The prospect of more U.S. money being put to work north of the border is of
course also long-term bullish for the Canadian dollar, which may be
overvalued now by about a nickel; however, at the same time, the fair-value
line keeps moving higher, which is a hallmark of a secular uptrend.
EARNINGS UPDATE
Bottom-up analysts are expecting another good earnings quarter; up 37% in Q1,
following the 200% YoY Q4 results (excluding financials, it was much tamer at
17%).
However, we would say that there are three items that need careful
consideration with regards to the seemingly bullish Q1 profit number.
1.Easy comparisons from last years very poor results. Financials are onceagain expected to see a large jump of 180% but also Materials andConsumer Discretionary are penciled in as growing +100% YoY. The other
thing to be mindful of is that oil prices were up nearly 100% as well on a YoYbasis from last year and this explains why the consensus is expecting +40%for energy earnings.
2.Revenues. Last quarter saw revenues up only 6% despite the massiveincrease in profits. This quarter, analysts are more bullish, thinking thatrevenues will be up closer to 10%. Unit labour costs in the nonfarmbusiness sector were down nearly 5% year-over-year and the question goingforward is how much more can firms cut in terms of costs. As HowardSilverblatt points out over at S&P, if we dont see sustained revenue growthgoing forward, then we wont see job creation.
3.S&P 500 profits versus NIPA (national accounts) profits. We took a quicklook at consensus estimates for Q1 (the S&P 500 profits) and seasonally-adjusted them to get a sense where economy-wide profits may be heading.To reiterate, the consensus is expecting a near 40% increase for Q1, butonce we translate this into seasonally adjusted terms, profits actuallydecline on the quarter (sequentially from Q4).
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MY TAKE ON THE U.S. Q4 GDP REPORT
For the second quarter in a row, we saw the final tally for U.S. GDP come in below the
initial estimate. Real GDP was marked down to a 5.6% annual rate in Q4 from 5.9%
in the second revision and from 5.7% in the advance reading. Recall that what was
once a giddy 3.7% annualized pace for Q3 was shaved to 2.2% in the final reading.
The overall contours of the fourth quarter data did not really change that much. Two-
thirds of the headline growth was accounted for by the arithmetic of a lesser
inventory drag and the remainder pretty well coming from net exports and capital
spending. However, these two areas cannot be relied upon based on the latest set
of monthly core shipments and new orders data, alongside what the stronger U.S.
dollar and Europes deepening fiscal woes will imply for U.S. corporate sales abroad
(Europe is twice as important as the B.R.I.C.s are, as an aside).
While business spending on equipment and software was revised up as companies
took advantage of the about-to-expire tax breaks, we saw nonresidential
construction, housing and consumer spending all marked lower. Ditto for State &
local government spending, which contracted at a 2.2% annual rate in real terms as
the contraction intensifies.
What was really key was the downward revision to overall real final sales, to a mere
1.7% annual rate from 1.9% in the previous version and 2.2% in the first release of
Q4 GDP. Ultimately, it is final sales that determine the veracity of the economic
expansion and the extent to which a lasting inventory cycle takes hold.
CHART 8: THIS IS A V-SHAPED RECOVERY?
United States: Final Sales of Domestic Product
(year-over-year percent change)
05050505050
10.0
7.5
5.0
2.5
0.0
-2.5
-5.0
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
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The 1.7% annualized pace to real final sales in Q4 followed an almost equally tepid
1.5% gain in the third quarter, which makes this the very weakest post-recession
performance (assuming we can call it that) on record outside of the extremely soft
rebound in early 2002. The only difference is that back then, Mr. Market was not
lulled into the belief that the economy had actually turned the corner.
So far in this post-recession recovery, real final sales have only managed to rebound
at a 1.6% annual rate despite all the gobs of government stimulus. To put it into
perspective, real final sales, by now, are usually rising at a 5% annual rate at this
point of other cycles, not sub 2% and those 5% growth rebounds did not require
nearly as much government support. If we do not see an improvement from this
trend, it would be consistent with profit growth of 5%, which at best would mean $70
for operating EPS for 2010. In other words, the market is possibly trading close to a
17x multiple on forward earnings (forward P/E ratio in the past has averaged 14.7x).
Going forward, the softer tone to demand means that we should not be expecting
inventories to add that much to overall growth. The capex orders and shipments
data are pointing to renewed stagnation in business spending and while commercial
real estate values have picked up from the floor, volumes are still extremely weak.
The accelerating decline in spending at the lower levels of government is offsetting
the stimulus efforts in Washington.
One of the best leading indicators of consumer spending is the expectations
component of the University of Michigan sentiment index, which just hit a four-month
low and is foreshadowing a halving in the underlying rate of household expenditures
to between 1.0% and 1.5% by the summer. Moreover, the latest data on housing
sales and starts are foreshadowing a renewed leg down in residential construction
after a brief recovery in that past two quarters. And net exports, given the strength in
the dollar and the clouded economic outlook in Europe, not to mention the after-
effects of the credit-tightening moves in India and China, cannot be relied upon to
contribute much, if anything, to headline GDP growth for the remainder of the year.
Its not so much a double dip outlook as one of very weak growth as far as the
outlook for the rest of 2010 is concerned both fiscal and monetary stimulus
will have faded and the impetus from inventory adjustments will have largely run
its course. The broad monetary aggregates have now either begun to stagnate
or decline outright; the ISM orders-to-inventory ratio has peaked out and leading
indicators, as well as their diffusion components, have rolled over across a
broad front.
So, I would be looking for a second-half growth relapse that sees theunemployment rate climb back to a new cycle high once the Census hiring effect
subsides and sees the stubbornly high unsold housing inventory drag home prices
down by at least another 10% in a scene that will look highly reminiscent of what
we saw in the back half of 2002. It wasnt a classic double dip recession like we
saw in the early 80s, but it was a growth relapse that defied V-shaped recovery
hopes at the time and ended up precipitating the unthinkable at the time and sent
both bond yields and equity indices back below their cycle lows.
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As an aside, the Gross Domestic Income (GDI) results for were also released for
Q4, and it came in better than I thought, at +6.7% annual rate (nominal), which
translates into +6.2% in real terms. That sounds good but Q3 was revised down
not just down but into negative terrain at -0.02% nominal and -0.4% in real
terms. What this means is that even though based on GDP, the recession
seems to have ended in Q2, on an income basis it only ended in Q3 and that is
only if the Q4 spurt in GDI is sustained.
The split was striking within the GDI report corporate profits soared at a 40%
annual rate while labour compensation only rose at a 1% annual rate. If you are
looking for a V, it has indeed been on profit margins or corporate earnings
relative to the economy, which have surged from a low of 7.4% a year ago, to
11.3% currently. Not only is that an unprecedented swing (mostly on cost
cutting) and now matches or exceeds every prior peak, save for the financial-
induced earnings bubble in the last cycle (see Chart 9). This occurred despite
the lack of top-line growth per unit pricing in the nonfinancial sector deflated
0.2% YoY, but unit labour costs have been cut for three quarters in a row and by
2.7% something we have not see happen in five decades.
CHART 9: CORPORATE PROFITS RELATIVE TO GDP
United States: Corporate Profits Before Tax to Nominal GDP
(percent)
05050505050
14
12
10
8
6
4
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
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CHART 10: STILL NO PRICING POWER
United States: Price per Unit of Real Nonfinancial Corporate Gross Value Added(year-over-year percent change)
05050505050
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
Source: Haver Analytics, Gluskin Sheff
CHART 11: UNIT LABOUR COSTS HAVE
DRIVEN THE PROFIT IMPROVEMENT
United States: Employee Compensation per Unit of
Real Nonfinancial Corporate Business Gross Value Added
(year-over-year percent change)
05050505050
16
12
8
4
0
-4
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
SHOW ME THE MONEY!
Liquidity conditions are beginning to tighten up with the just-released weekly
data from the Fed showing M2 growth slowing precipitously and now negative
on a year-over-year basis in real terms. MZM is already contracting in both
real and nominal terms. Bank credit continues to shrink by 8.6% YoY and
over 11% on a 13-week rate of change basis.
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CHART 12: M2 GROWTH AT A 15-YEAR LOW
United States: Money Stock: M2
(year-over-year percent change)
050505
15.0
12.5
10.0
7.5
5.0
2.5
0.0
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
CHART 13: MZM NOW CONTRACTING
United States: Money Stock: MZM
(year-over-year percent change)
050505
40
30
20
10
0
-10
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
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CHART 14: BANK CREDIT CONTRACTION GAINS DOWNSIDE MOMENTUM
United States: Loans & Leases in Bank Credit for Commercial Banks(year-over-year percent change)
05050505
20
15
10
5
0
-5
-10
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
The money supply data is suggesting that the contraction in credit is now
starting to dwarf the Feds efforts at bolstering bank reserves efforts that
will subside after March 31 when the central bank stops buying MBS and lifts
the discount rate another 50 basis points to re-establish the pre-crisis spread
off of Fed funds.
No doubt there were periods in the past when the equity market did just fine
with lackluster money supply growth, but that only happened when economicand earnings growth really kicked into high gear. Not only is the consensus
currently looking for the YoY EPS growth numbers to soon subside, albeit from
blowout numbers last quarter due to depressed 2008 and early 2009 levels, but
in seasonally adjusted terms the bottom-up consensus is actually looking for
EPS to decline this quarter from the fourth-quarter level. Receding liquidity
coupled with a slower earnings profile promises to shift the investment landscape
towards a more defensive tilt over the near- and intermediate-term, in my view.
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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 December31, 2009, the Firmmanaged assets of$5.3 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 $10.7million2
onDecember31, 2009 versus $5.5 million forthe S&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 $11.7millionusd
2on December 31, 2009 versus $9.2
million usd for the S&P500TotalReturn Index over 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.
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.
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-followed and under-appreciated smalland mid cap companies 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.
Our investmentinterests are directlyaligned with those ofour clients, as Gluskin
Sheffs management andemployees arecollectively the largestclient of the Firmsinvestment portfolios.
$1 million invested in our
Canadian Value Portfolio
in 1991 (its inception
date) would have grown to
$10.7 million2 on
December 31, 2009
versus $5.5 million for the
S&P/TSX Total Return
Index over the same
period.
For further information,
please contact
Notes:
Page 18 of 19
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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