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Equity markets typically go through a number of phases during an

economic cycle. After an initial recovery rally, it is very common forstocks to correct as economic growth decelerates and investors start tofear the dreaded double-dip recession. Luckily, double-dips rarely

occur and stocks almost always resume theirrally as the signs of asoftlanding become more evident. However, this economic cycle is very

different than any in the postwar era and there are well-founded fearsthat a double-dip recession is more likely than in previous economicrecoveries. The capital markets behavior in the third quarter reflected

these concerns. Stock markets hit an air pocket in the middle of thequarter as economic data decelerated and fears of sovereign debt crises

continued to linger. However, equities began to find their footing onthe first signs of stabilization in key economic variables and thenralliedhard! The 8.9% Septemberrally for the S&P 500 Index proved

to be the strongest one for that month since 1939. The MSCI WorldIndex recovered to finish up 13.9% in the quarter (10.4% in Canadian

dollar terms) while the S&P/TSX Composite Index ended up 10.3%.The Index groups with the best performance in Canada were the

Materials, Utilities and Consumer Staples sectors.

The chances of a double dip are higher this cycle due to the almost

unparalleled challenges that the world economy is facing, especially inthe more developed regions of the globe. Many countries are grappling

with the headwinds of significant private sector debt de-leveraging,massive governmentdeficit spending and centralbanks seeminglyrunningout of bullets when it comes to furtherways to stimulate their economies.

The economic recoveryto date has been much more anemic than usualwhich has raised more legitimate fears of an impending recession.

As the recovery began to lose steam earlierthis year, we started to mon-

itor a number of key short-term variables that we thought would be

important to resolving the ensuing soft landing versus double dipdebate. Many of these variables, including the US and Chinese

Purchasing Managers Indices as well as US employment data, havebegun to signal that the recent softness in the economy is stabilizing.

To be clear, we dont expect the global economy to suddenly surge.However, we also dont believe that strong growth is necessary forequities to rally considerably from current levels. What is necessary is

to have at least some positive growth that can sustain itself for areasonable time into the future. An economy showing at least some

sustainable growth allows deflationary fears to subside withoutprovoking inflationary fears. It allows risk seeking behavior to increase

and investors to refocus on stock picking as opposed to macro

economic analysis and the worries of higher stock correlations thatoccur in more intensely macro-driven environments. Investors can

generate solid returns in a tepid economic recovery if the recoverysustains itself and if valuations are attractive. We believe both of theseconditions exist today.

One simple reason for the economy to continue grinding higher

instead of slipping into recession is the current lack of consumptionexcesses that have typically begun to emerge at this point in priorstronger recoveries. For instance, it will be difficult for the US housing

sector to fall substantially from current levels when US housing startsare still below bottoms from prior recessions and are not even keeping

up with the level of household formations. Similarly, US auto saleshavent been at levels this low since the early 1990s causing the average

age of cars on the road to increase significantly. Consumers havereduced their spending in order to begin rebuilding their savings. Withthis much savings rate adjustment having already occurred, it becomes

increasingly difficult for consumer spending to remain such a largedrag on the economy. Of course should the economy still manage to

stumble the US Federal Reserve is prepared to embark on anotherround of quantitative easing. Just the Feds announcement that it wascontemplating such a move has led to some of its benefit already being

felt in the US through recent declines in longer term bond yields andthe US dollar.

There is also a very large source of pent-up economic growth potential

emanating from unsustainably low levels of corporate capital spending.The ratio of US corporate cash flow to non-residential fixed invest-ment is at the highest levels it has been since at least the late 1940s. US

corporations are producing almost as much as they did near theeconomic

peak, but with much lower labour costs. Machinery is aging and theworkforce may be getting overworked. It is possible that the recentimprovement in the tone of the stock market will improve corporateconfidence and kick-start capital spending programs. Increasing corporate

capital spending should lead to greater job gains and increasingconsumer incomes which should help reinforce the sustainabilityof the

economic recovery.

Unlike in past recoveries, the global economy has benefitted much

more from strong growth in the emerging economies. All eyes havebeen recentlyfocused on China which is a key driver of emerging economy

PICTON MAHONEYASSETMANAGEMENT

CANADIANEQUITYINVESTMENTOUTLOOK

OCTOBER 2010

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PICTON MAHONEYASSETMANAGEMENT

CANADIANEQUITYINVESTMENTOUTLOOK

The past three years have not been kind to many types of disciplined

stock selection strategies. One reason for this has been investorsintense focus on macro economic factors and the potential for adverse

events occurring within the global economic system. According torecent research done by Bernstein Research when a lone factor (such

as risktoday) has dominated stock returns, the market trades with highcorrelation. Correlation drives mispricings of stocks and as it persists,the opportunity set of the market grows. The return of differentiation

among stocks will occur when investors regain conviction and act to

profit from this. The recent signs of economic stability may be settingthe stage for stock selection to begin playing a bigger part in portfolioreturns going forward.