Breakfast With Dave 052110

8/8/2019 Breakfast With Dave 052110

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David A. Rosenberg May 21, 2010Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

More selling pressure in overseas equities to end the week Asian markets are

down to nine-month lows after todays additional 1.3% shellacking. Bond

markets are consolidating though with a bullish bias JGB yields down an extra

2bps to 1.22%.

The latest news is that Tim Geithner intends to meet with European officials next

Wednesday to discuss the European debt crisis, and if he knows anything, he

knows bailouts (Mexico in 1995, LTCM in 1998, banks in 2009). There is always

the risk of a coordinated FX intervention and there will be plenty of time forEuropean policymakers to meet over the long weekend to come up with another

plan to burn those evil speculators (they are benevolent, however, when they are

buying the debt) see EU Chiefs Cant Live With Markets, or Without on page A8

of the WSJ. Meanwhile, the first trillion bazooka, which just got approved by the

German lower house of parliament, has done little to ease concerns of a Greek

debt restructuring because CDS spreads imply a 47% chance of default.

On the data front, the key German Ifo business confidence index dipped, but just

a tad, in May to 101.5 from 101.6 in April (dont ask us why the consensus

thought it would rise to 101.9). The U.K. also posted a record deficit for April,

and so the new U.K. government, like so many others, will have its feet to the

fire in terms of requiring a sizeable fiscal tightening going forward. This is key

for a world economy that has been revived mostly due to the rampant stimulusand bailouts of the past 12-18 months (this stimulus was candy for Mr. Market).

As Fed Governor Daniel Tarullo said during a House hearing recently on the

European debt situation, their experience is another reminder, if one were

needed, that every country with sustained budget deficits and rising debt

including the United States needs to act in a timely manner put in place a

credible program for sustainable fiscal policies.

Leading indicators are beginning to top out and this augurs for a more defensive

investment strategy its not too late. After all, copper is heading for its sixth

weekly decline in a row that must be telling you something about the global

economic outlook (and specifically that Chinese imports are starting to decline).

Home prices are beginning to weaken again under the weight of huge excesssupply (this process is also under way in Canada where the bloom is off the

rose). And, 470k on U.S. jobless claims leaves doubt that we are actually

embarking on a sustained job creation cycle no matter what the Bureau of Labor

Statistic (BLS) data show.

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

Green shoots! Thenumber of insuredcommercial banks andsavings institutions on theFDICs problem listcontinues to grow

Reversion to the mean:going back 64 years, we

have never seen a timewhen the stock marketcorrected this much in theso-called sweet spot of

the cycle

But the fundamentals aregreat! We hear this all the

time, but thefundamentals are actuallyless solid than many think

Market thoughts: we couldsee a near-term bounce

that should be faded asthe market is oversold

U.S. initial jobless claimsdata consistent with joblosses, not gains

The leaders begin to lag:the index of U.S. leadingeconomic indicators (LEI)fell 0.1% in April the firstdecline since March 2009

Deflation remains theprimary trend in the U.S. and the Federal Reserveknows it too

The Philly Fedmanufacturing indexedged up in May, but thegood news ended there as

the components were softacross the board

While you were sleeping:more selling pressure inoverseas equity markets toend the week

IN THIS ISSUE


2/9

May 21, 2010 BREAKFAST WITH DAVE

We shall find out soon enough if Mr. Carney left himself enough wiggle room to

sit out the June 1 policy meeting the market and the consensus see a rate

hike. We lay 60% odds that he sits this one out despite the earlier saber-rattling

and todays higher-than-expected CPI data for April. For purely practical matters,

one has to wonder why the BoC would not opt to delay the rate hikes seeing as

the Fed has already chosen to delay its planned balance sheet shrinkage.

For the economy, it cannot

be a bad thing to have oilprices come down, which

helps add cash to consumer

pocketbooks and protect

profit margins

If this European crisis has accomplished anything, it has taken the froth out of

commodity prices. Even gold is softening but every time it goes to test the 200-

day m.a. now at $1,100 oz it becomes a great buying opportunity.

Moreover, this has all but eliminated the overvaluation gap in the Canadian

dollar for the first time in four months.

Take note that there was not one particular piece of news that drove the

markets lower yesterday and this is key because it goes to the root of Bob

Farrells rule that the markets make the news, the news does not make the

markets. There are simply now more sellers than there are buyers because

portfolio managers went into this latest chapter of the global credit story fully

invested, the hedgies had already met their high-water marks, the shorts had

been covered long ago and the general investing public seem to be in a multi-

year phase of bolstering its underweight position in the fixed-income market.

Moreover, the pig farmers at the prop desks at the big banks, the ones who

drove the last leg of the bear market rally, seem to be placing their bets the other

way right now and with few bids, the prices are adjusting lower (the flash crash

was an exaggerated version of how a market can move when there is no bid).

Since much of the bear market rally off the March 2009 lows was technical rather

than fundamental in nature, one cannot rule out a move down towards the 900-

950 area for the S&P 500, which is where a classic retracement would take it; not

to mention where it would offer fair-value on a normalized P/E ratio basis.

As it stands, this is the first official correction in equities since the market came

off the lows 14 months ago:

The S&P 500 is now down 12% from the nearby highs. The Russell 2000 is down 14%. TSX is down 7%. Oil is down 21%. Copper down 19%. The CRB is off 15%. The yield on the 10-year note is down 80bps. Investment grade corporate spreads have widened 61bps while high-yield

spreads have moved out 161bps.

The VIX has surged 193%. The euro is down 15% and while the CAD has outperformed its commodity

counterparts, it has sagged 7% from the recent highs.

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Since the market highs in the S&P 500, the best performing equity sectorshave been Telecom, Consumer Staples, and Industrials; the worst three have

been Financials, Energy and Health Care in a sign of how the complexionhas shifted towards a less cyclical stance.

While we did have a few

quarters of respite in U.S.

consumer spending, make

no mistake that the trend is

down, not upLook, theres no sense getting overly bearish and while those of us with cash on

hand that had been waiting for this opportunity in Godot-like fashion, the

correction comes as good news. But for the economy, it cannot be a bad thing

to have oil prices come down, which helps add cash to consumer pocketbooks

and protect profit margins, and of course this wonderful bond rally has acted as

a source of social policy seeing as it has helped pull mortgage rates down to six-

month lows, to 4.8% for the U.S. 30-year fixed rate product.

While we did have a few quarters of respite in consumer spending, make no

mistake that the trend is down, not up (real per capital household spending has

not even made a new high yet) and the frugality theme we introduced more than

two years ago is fully intact. For some evidence on this front, the just-releasedUSA Today/Gallup poll show that 27% of Americans plan to travel less this

summer; only 18% intend to travel more. This will likely put a dent in the hotel

and airline sectors, which, according to the latest CPI statistics, had been

showing some nice pricing power improvement in the past 2-3 months.

The must read of the day, if there is one, is the Paul Krugmans column on page

A23 of the NYT Lost Decade Looming? He starts off with despite a chorus of

voices claiming otherwise, we arent Greece. We are, however, looking more

and more like Japan.

We have been saying this since late 2008 when the Fed dropped the funds rate

to zero and that still couldnt put a floor under either the economy or the equity

and debt markets. What did put in a bottom was an experimental toolkit that

involved an unprecedented expansion of the central banks balance sheet,

which is now concentrated more in residential mortgages than in government

securities. One other thing it is not one lost decade in Japan, it is two.

The equity market is

technically oversold rightnow and is due for a near-

term bounce, but that would

be a rally that I would fade if

we see it

MARKET THOUGHTS

The equity market is technically oversold right now and is due for a near-term

bounce, but that would be a rally that I would fade if we see it. There has been

too much of a rupture to ignore with the S&P 500, Dow and Nasdaq all closing

below their 200-day moving averages (fist time in almost a year for the Nasdaq).

There were only 11 new highs yesterday and 212 new lows, so this ratio is still

quite bleak. Decliners/advancers were also 11-to-1 on the major exchanges.

This is what I mean by rupture.

On average, corrections that take place after such a massive move up from a

depressed low is 20%, which would mean that we could expect to see the S&P

500 still test the 970 level; with a prospect of a second-order Fibonacci

retracement implying a move below 950. Remember that before the last big leg

up in the market last summer, the S&P 500 was hovering around the 920 level,

which is my target to begin getting interested again.

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A 10% correction, even in a bull market, is pretty normal, and historically has

occurred about every 12 months and tends to occur more in the second year

of a rebound, or bull market, than in year-one. So the European debt crisis is

certainly the catalyst for this renewed round of risk aversion, but is not out of

line with market patterns over the past century.

To turn bullish, we would

need to see Libor-OIS

spreads begin to narrow

again, corporate spreads

tighten, and stability in the

euro

Two critical data points to watch for the May 6 flash-crash intraday low of

1,065 on the S&P 500, followed by the 1,044.5 low on February 5. If these

dont hold, and the bulls need these levels to hold, then another leg down to or

through the 950-970 levels is likely.

To turn bullish, we would need to see Libor-OIS spreads begin to narrow again,

corporate spreads tighten, and stability in the euro. That would be important

signals from the other asset classes. Technically, it would be encouraging to see

two big up-days in the stock market with large volume we need a follow-

through with huge participation. It would also help if market sentiments swung

towards the bearish camp believe it or not, the most recent Investors

Intelligence survey has the bulls at 43.8% and the bears at 24.7%. At the lows,

we would expect these numbers to be reversed.

The fly-in-the-ointment is that unlike 1987 or 1998, this is not just a financial

crisis but one that is occurring with the global economy in a post-bubble fragile

state if it is a recovery, it is a nascent recovery. And, already we see that the

U.S. leading economic indicator fell in April, which is unusual at this early stage

of the cycle, and jobless claims heading back above 470k, if sustained, is

worrisome because in the past this has coincided with job losses fully 75% of

the time. By the time the jobless recoveries were over and done with in 2003

and 1993, claims had already moved down to 400k in the former and 350k in

the latter. And, practically every house price measure in the U.S.A. is rolling over

right now. The lesson of 2002 is that market priced for perfection does not even

need a classic double-dip to falter a simple growth relapse will do the trick.

CLAIMS DATA CONSISTENT WITH JOB LOSSES, NOT GAINS

U.S. initial jobless claims jumped 25k to 471k during the week of May 15 just

in time for the nonfarm payroll survey week. This is the highest print in five

weeks and adds confirmation to the view that claims have stopped falling after a

huge decline in the second half of last year.

We went back into 50 years worth of data and found that when claims were this

high: (i) 75% of the time employment is declining; and, (ii) the average monthly

falloff is 150k so, put that in your pipe and smoke it!

In addition, the total number of claimants fell 189k to 9.9 million, the low water

mark for the year and down from the nearby peak of 11.9 million. We wish this

was somehow related to the ranks of the long-term unemployed seeing a

tremendous wave of job opportunities and responding in kind (the consensus

view) but it could well simply be the case that these folks have run out of benefits

(after 99 weeks) with Congress deciding not to vote for yet another extension.

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THE LEADERS BEGIN TO LAG

The U.S. LEI fell 0.1% MoM in

April seeing the LEIdecline this soon after a

recession supposedly ended

is definitely not normal

The U.S. leading economic indicator (LEI) dropped 0.1% MoM in April, which

came as a surprise to a consensus view of +0.2% MoM and was the first

monthly decline since March 2009, at the market lows. Not only that, but the

diffusion index dropped to 40% in May and this too was the poorest reading

since last March. Seeing the LEI decline this soon after a recession supposedly

ended is definitely not normal it didnt decline for four years after the last

recession ended in November 2001 (and that included the 2002 relapse).

Not only that, but the LEI is grossly overstated because the yield curve, just by

virtue of staying steep (the way it is calculated, it doesn't even have to move)

adds nearly a 0.4 percentage point to the LEI each and every month. So outside

of that, the LEI was down 0.5%; and, if you remove the tenth of a percentage

point upside influence from the stock market last month, the LEI would have

been down 0.6%, which is what it was doing back in the fourth quarter of 2008!

Back in April 2009, at the onset of the bear market rally and the green shoots, the

LEI was +1.1 MoM and the coincident index was -0.4% and the lagging index was -

0.6%. Fast forward to April 2010, and the LEI was -0.1%, the coincident index was

+0.3% and the lagging was +0.1%. The mirror image. Caveat emptor.

DEFLATION REMAINS THE PRIMARY TREND ... AND THE FED KNOWS IT TOO

The Cleveland Fed just published a report on inflation concluding that: (i) the

decline in recent months has transcended the housing effect; and, (ii) the principal

risk is for a further slowing. Treasury yields are likely headed even lower. The title

of the report isAre Some Prices in the CPI More Forward Looking Than Others? We

Think So, by Michael F. Bryan and Brent Meyer and well worth a read.

Abstract:

Some of the items that make up the Consumer Price Index change prices

frequently, while others are slow to change. We explored whether these two

sets of prices sticky and flexible provide insight on different aspects of the

inflation process. We found that sticky prices appear to incorporate expectations

about future inflation to a greater degree than prices that change on a frequent

basis, while flexible prices respond more powerfully to economic conditions

economic slack. Importantly, our sticky-price measure seems to contain a

component of inflation expectations, and that component may be useful when

trying to gauge where inflation is heading.

The Cleveland Fed just

published a report on

inflation concluding that the

decline in recent months has

transcended the housing

effect and the principal risk

is for a further slowing

Conclusion:

Where is inflation heading? Well, the last FOMC statement held the view thatinflation is likely to be subdued for some time. We certainly dont have reason to

question that outlook. Indeed, while the recent trend in the core flexible CPI has

risen some recently (its up 3.3 percent over the past 12 months ending in March)

the trend in the core sticky-price CPI continues to decline. Even excluding shelter,

the 12-month growth rate in the core sticky CPI has fallen 1.1 percentage points

since December 2008, down to 1.8 percent in March. So on the basis of these

cuts of the CPI, we think subdued for some time sums up the price trends nicely.

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What is normal is that during the sweet spot period, the equity market is up

15% from the lows, not 80%. Depending on whether you calculate the 15% off the

first low in November 2008 or the second low in March 2009, it would not be a

stretch to see this market trade down to below 900 on the S&P500 before the

interim low is turned in. In this latest phase, the steepest advance was 30%,

which would therefore mean, if you want to be early at calling the low, a test of the

870 to 975 range would be your band in which to scale back in.

Currently, the fundamentals

are actually less solid thanmany on Wall Street are

letting on

BUT THE FUNDAMENTALS ARE GREAT!

We hear this all the time; almost as many times as we hear but were off the lows

for the session on CNBC almost every day since the highs were put in three weeks

ago. Its not always about how great the lagging or coincident indicators are

(especially when the ECRI leading index is down to a 40-week low). As we have

said time and again, to some testy retorts we must add, overvalued markets are

more vulnerable than undervalued markets. Simply put.

We had a nasty near 20% correction back in the summer and fall of 2002 and

yet we had come off a 3.5% annualized GDP quarter to start the year, which at

the time got a lot of folks in a tizzy. Real GDP printed +8% in the second

quarter of 2000 just as the Nasdaq was rolling off the highs, and never to look

back again at those lofty peaks not to mention the huge 300k job gains at

the time. By the first quarter of 2001, GDP was falling at a 1.3% annual rate.

Who was calling for that a year before when the fundamentals were viewed as

being so solid by the economic elite at the time.

What about 1998? In the same quarter that the S&P 500 cratered 20%, due

no less than to the fallout from the Asian crisis, real GDP in the U.S. was up at

a ripping 5.4% annual rate and nonfarm payrolls were rising 250k per monthto perpetuity, or so it seemed. We had a big turndown in the financials back in

1994 and lo and behold, it took place with real GDP advancing at over a 4%

annual rate and payrolls increasing 300k per month.

Then in the mother of all corrections in October 1987; that same quarter of

the collapse, we had real GDP up at a resounding 7% annual rate and

employment rising 300k per month yet again. So, the message here is to

trade and invest carefully in an overvalued market, which is what each of

these periods had in common.

As for the current situation, the fundamentals are actually less solid than

many on Wall Street are letting on. It will be interesting to see what the fallout

is on spending and confidence from this latest market downdraft (it seemsmore than a 10% correction, doesnt it?) and intense volatility since the only

reason why everyone was of the belief that the economy had made the full

shift from recession to recovery was because the 80% surge in equity prices

told them that this was the case. Yes, the same stock market that peaked

right when the recession did in the fourth quarter of 2007 may yet again have

peaked right at the highs of this nascent, but fragile, renewal phase.


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Breakfast With Dave 052110