David A.

Rosenberg May 27, 2009

Chief Economist & Strategist Economics Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
There is significant spill over from yesterday’s super-positive U.S. action to the IN THIS ISSUE
Asian equity markets, which hit their highest level in eight months today – up • Why the U.S. will not get
1.6% on the session. The Hang Seng index soared 5.4%, Taiwan by 3.1% and downgraded, in our view
Japan by 1.4%. All the risk-preference trades are in vogue – Sterling hit the 1.60
• Home prices continue to
mark for the first time in six months, copper just reached a three-week high, oil
deflate, down 2.2% MoM
has broken above $63/bbl (up 1% so far today), and gold is off. The crude oil in March and -18.9% YoY
price received a nice lift in particular from comments out of the Saudi oil
• The equity markets
minister (Ali Naimi) who said that the world could live with $75-80 oil.
surged on the back of the
Conference Board
Treasuries are tremendously oversold but as we saw in the summer of 2007 consumer confidence
when they broke to 5.3%, there is always a risk of an overshoot. They are ever report
so slightly bid this morning as the Fed is going to come in today and purchase
• The Chicago Fed’s
T-notes that mature between May 2012 and August 2013 and this is helping national activity index
provide a bit of a better tone right now (though there is $35 billion of new 5-year entrenched in recession
supply hitting the market today). terrain

All eyes on U.S. existing home sales for April this morning as the ‘green shoot’
advocates are back on the front burner. According to Bloomberg News, the
latest NABE (National Association of Business Economists) survey shows that
the consensus believes the recession will end next quarter. If the consensus is
right – as it is generally less than 20% of the time – then the lows of March 9
should indeed hold based on the typical lags between bear market and business
cycle troughs.

On the data front, pretty light today -- the closely-watched Belgian business
sentiment index came out earlier and was below expected in May, at -27.6
(consensus was -27). German state inflation data so far in May are coming in
negative for the month, which is below expected. Exports in Asia are starting to
revive – Japan saw its YoY trend in April at a still negative 39% but this was
better than the -42% that was widely expected, and on a MoM (seasonally
adjusted) basis, outbound shipments rose 1.9%.

What’s the next shoe to drop? Commercial mortgages, no doubt. According to

Bloomberg, S&P is on the precipice of cutting a significant tranche of high-grade
loans that were issued during the debt binge from 2005 to 2007 – which of
course could then affect the debt that is eligible for the TALF program.

Please see important disclosures at the end of this document.

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May 27, 2009 – BREAKFAST WITH DAVE

YESTERDAY’S ACTION
The bond market got beaten up again – the confidence index seemed to win out
over the home price data. The bond market sold off sharply even though the 2-
year note auction went rather well (2.94x bid-to-cover ratio versus a 2.43x
average over the last ten auctions). We hear that technically the 3.56% is a
critical level of support, and as we said late last week, the worst-case scenario is
a move to 4.1% on the 10-year T-note. This is all very reminiscent of that sharp
spasm we saw back in the summer of 2007. The only difference is that the
‘inflation-adjusted’ real yield back then was 3% and today it is a juicy 4 ¼%.

The equity market rallied sizably and responded largely to the booming
consumer confidence number, which we would classify as a third tier economic
indicator (the Russell 2000 soared 4.8%, snapping a four-day losing streak, but
the gain was led by the homebuilders even though house-buying intentions were
the weakest link in the consumer confidence report!). It may tell us something
about hope, but it doesn’t feed into GDP or corporate earnings. The S&P 500, at
910, is still below the 928 nearby peak on May 8 and the 937 peak for the year
posted back on January 6, which begs the question, did we just see a double
peak? Since that interim May 8 high, we have endured three triple-digit down
days and three triple-digit up days. So, all Mr. Market is really telling us is that
he is currently in a very volatile mood.

We had a reader email us yesterday who stated “I am finding it harder and

harder to reconcile reality with your analysis.” Well, as I have said in the past,
this is still a bear market rally until we see the improvements in the second
derivative begin to morph into first derivative improvements. The risk, as I see it,
is much the same as in late 2001 and early 2002 when the recession ended but
the recovery was aborted until we were into the second half of 2003. Asset
deflation and credit contraction cycles never play out according to the historical
script, which is one reason why we remain cautious and not at all trusting over
the durability of this market bounce of the last two months. In other words, this
should be treated as a bear market rally. The only meaningful change in my
view is that I am no longer as sure as I was before that we will go back to the old
lows of March, but I still think a testing phase will be in order.

As for “reality” – well, tell me, what is the reality? What was the “reality” when
the market was up 2% for the month, 15% over the prior year and the Dow up a
resounding 120 points on the very day of the peak back on October 9,
2007. I’m sure the reality at the surface was that we had a Goldilocks
economy. The reality a few months later was quite different with the onset of
recession, and this was before Bear Stearns and Lehman collapsed. So, the
market will do what the market will do, which is to overshoot and undershoot in
both directions. As I see it, what the market has done is price out the recession,
but please , at 900+ on the S&P 500 (where it was when Warren Buffet told you
to buy the market last October), I’m not sure it’s telling you much about the
shape of any recovery. Plus, as we show below, bullish sentiment has recently
risen to near-extreme levels, which is bearish from a contrary perspective.

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May 27, 2009 – BREAKFAST WITH DAVE

Be that as it may, the big risk now for the cautious (our) view of the market is
less the fundamentals and more the fund flows; we are aware that portfolio
managers are sitting with $3.5 trillion of cash, and the major upside risk is that
they start to chase performance. At the least, the temptation to now “buy the
dips” could well ensure that the lows have been put in and that it would take a
2002-style relapse in the economy and adverse corporate news (ie, Enron,
Worldcom back then) to trigger a setback to fresh cycle lows. We have not
changed our views on the macro outlook, but the markets have a tendency
historically to overshoot in both directions. We have to be mindful of that. But
for the time being, it does look as though all we are seeing is backing and filling
and a consolidation with the early May interim highs.

WHY THE U.S.A. WILL NOT GET DOWNGRADED

I realize this it is borderline heresy to say anything positive about the U.S.
economy so I will just say something that is less positive. It is highly unlikely that
the U.S. government will ever default. Why? Well, it can always print dollars –
and all its liabilities are in dollars. Not only that, but it was comical to see the
markets focus on the U.S. dollar and the Treasury market following the
downgrade to the U.K.’s credit outlook. There is no use comparing the
diversified economic base between the two countries. Not only that, but the
taxing capacity in the United States is much larger – government revenues
absorb 42% of national income in the U.K. versus 33% in the U.S.A. Those
comparable figures are 43% in Germany, 46% in Italy, and 49% in France. In
Canada, it is 40%. But here is the grim reality for American workers, especially
those in the upper income echelons. The President ran on a campaign to
redistribute income, and at the same time he has beefed up what was already a
near-intolerable deficit, and as we saw in the 1930s as the top marginal tax rate
climbed to nearly 80%, Uncle Sam is going to be increasing its revenue take for
a long, long time. The era of the word ‘tax’ being a dirty three-letter words in the
United States is about to come to a close, if it hasn’t already in areas like New
York, where the top rate has already risen to 46%. Shades of Ontario during the
Rae years of the early 1990s.

HOME PRICES STILL DEFLATING

U.S. home prices (according to the Case-Shiller home price index) continue their
descent – down 2.2% in March and -18.7% on a year-over-year basis. Prices are
now down 32% from their 2006 highs and there is still no sign of relief. Just
wait until the post-foreclosure-moratorium inventory surge hits the market in
coming months – prices will adjust even lower. (Note that RealtyTrac just
released its April data and found that a record 340,000 default notices were
handed out during the month.) All 20 metropolitan areas are deflating year-on-
year, with Phoenix, Las Vegas and San Francisco still the major culprits in this
never-ending story. Overshooting to the downside as much as they overshot the
upside would mean the prospect of another 20-30% decline from here.
Meanwhile, plain-vanilla mortgage rates have stopped falling and jumbos are on
the rise; not only that, but keep in mind that the rental vacancy rate nationwide
is now over 10%.

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May 27, 2009 – BREAKFAST WITH DAVE

Chart 1: HOME PRICES — STILL DEFLATING AFTER ALL THESE YEARS

United States
S&P/Case-Shiller Home Price Index: Composite 20
(Jan 2000 = 100, seasonally adjusted)

220

200

180

160

140

120

100
00 01 02 03 04 05 06 07 08

Source: Haver Analytics, Gluskin Sheff

THE MARKET SURGED ON THE BACK OF THE CONFERENCE BOARD

CONSUMER CONFIDENCE REPORT FOR MAY
• The headline index surged to 54.9 from 40.8 in April and the 25.3 low in
February. The 29.6 point jump over the last three months is a record. This
will revive the ‘green shoot’ advocates.
• The confidence index is back to where it was in September when the
economy was nine months into recession. In the last two recessions, as an
example, the end of the recession coincided with this index north of 80. So
it is telling us what so many other indicators are signaling which is it that
things are “less bad” than they were; but this is not enough to terminate the
recession call.
• The bulk of the increase in the index was in “expectations”, which surged to
72.3 from 54.0 in April – to stand at its best level since December 2007!
This index is influenced largely by the rally in the equity market, which
becomes circuitous since the market then rallies off a number like this.
• The ‘facts on the ground’ present situation component came in at 28.9,
which was marginally better than the 25.5 print in April – but less than half
where it was last September (61.1). This is key because it tells us that the
delta in this report from consensus all came in the form of hope, not
necessarily reality.
• Interestingly, the homebuying intentions component fell to a three-month
low (but plans to buy a major appliance rose to its highest level in eight
months). Auto buying plans rose to its best level since April 2008 so the
incentives may be working for the time being. Consumer intentions to take
a vacation fell to its lowest level in 41 years!

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May 27, 2009 – BREAKFAST WITH DAVE

• Finally, the share of households who are bullish on equities rose to 35.8%
from 31.7% in April and the March low of 19.6% (this is the highest since
July 2001). The ‘bear share’ fell to 30.8% from 35.7% (was 52.8% at the
March market lows) — the lowest the bear share has been since October
2007. Could be the hidden ‘contrary’ negative data-point in a report that is
being viewed as widespread bullish for equities.

• THE LAST TIME THAT THERE WERE MORE EQUITY MARKET BULLS (35.8%)
THAN BEARS (30.8%) WAS BACK IN OCTOBER OF 2007 WHEN THE MARKET
WAS HITTING ITS PEAK. THIS METRIC WORKS LIKE A CHARM BECAUSE
LAST MARCH, AT THE MARKET LOWS, THE GAP BETWEEN THE BEARS
(52.8%) AND THE BULLS (19.6%) IN THE OTHER DIRECTION WAS THE
LARGEST SPREAD SINCE JULY 2008 (AND THE SECOND LARGEST GAP ON
RECORD).
• As for bonds, as a sign of how negative the sentiment is, the share who see
yields backing up rose to a six-month high of 47% from 39% in April. The
share believing that interest rates will head lower slid to 18.1% from 23.4%.
The last time there was such a huge differential between the bond bulls
and bond bears (in favour of the bears) — by 29 percentage points — was
back in September 2007 when the bull market in Treasury was just getting
going. Just to show how great a contrarian this indicator is, at the
December lows in bond yields (when the 10-year note touched 2.0%),
39.4% of the public were bond bullish (an eight-year high) and only 30.9%
were bearish (the lowest in over seven years!).

We can understand that any piece of good news is going to be pounced on as a

sign that the recession is over or about to be over. We noticed a lot of
economists pointing to the fact that the “expectations” index is some critical
barometer of the future. All we can say for investors is that the reliability of
these confidence surveys in predicting anything of importance is highly
questionable. Just as an example, the “expectations” component of the survey
peaked in May 2000. The recession didn’t begin for another 10 months. Then
it bottomed in March 2003, a year-and-a-half after the recession ended. And
when did it peak? Try December 2003 — and the bull market and the economic
expansion had another four years to run. Interpret surveys like these very
carefully — the fabled “expectations” index has the grand total of a 33%
historical correlation with consumer spending growth. Feeling better doesn’t
always necessarily translate into opening up the wallet.

Interesting that so much attention was paid to that ripping Conference Board
survey for May, when there was a lack of validation from the ABC News
consumer comfort index, which slid to -47 in the May 24th week from -45 the
week before and -42 the week before that. It was also fascinating to see that
the “personal finances” segment has eroded the most over this time period
(to -8 from -4 and +4 — a 12 point swing in two weeks) since it was the equity
market bounce that supposedly gave that nice “expectations” induced lift to the
Conference Board survey.

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May 27, 2009 – BREAKFAST WITH DAVE

Perhaps the Conference Board survey Chief Lynn Franco put it best when she
said that “less pessimistic is the best way to describe consumer attitudes” and
noted that even with the stock market’s exuberant response, May was “still a
weak reading” and “not a very optimistic number”.

In any event, there is still plenty of evidence that the American consumer is
undergoing a secular change in behavior, and as vacation plans are cut back,
what is replacing the plane trip to the theme park are camping trips – welcome
to the frugal future. Good article on this in the USA Today (Go Camping to Cut
Vacation Costs). For investors, this may mean running “company screens” on
sales exposure to tents, flashlights and sleeping bags!

CHICAGO!
One of the best barometers of the economy is the Chicago Fed’s national activity
index, which blends together 85 different variables — a number below zero
highlight an economy operating below its potential, but data below -0.70
represents an economy in contraction phase. In April, the index (the 3-month
smoothed, which the Chicago Fed says is the key metric to monitor), the index
was -2.65, which indeed was “better” than the -3.29 print in March and the
terrible -3.68 low for the cycle posted in January. What this index is saying is
that the recession is intact, with very little light at the end of the tunnel, with the
only reasonably positive highlight being that it is off its worst levels when pundits
were talking about “depression” and “widespread nationalization” at the turn of
the year. At -2.65, the Chicago index is basically back to where it was in
November, and even slightly worse than it was in September when LEH
collapsed (-2.23). At the current pace of improvement, this metric does not hit
the zero mark until the end of this year.

Chart 2: CHICAGO FED’S NATIONAL ACTIVITY INDEX ENTRENCHED IN

RECESSION TERRAIN
United States

FRB Chicago National Activity Index: 3 Mo. Moving Average

(+ = growth above trend)

-1

-2

-3

-4
70 75 80 85 90 95 00 05

Shaded area represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

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May 27, 2009 – BREAKFAST WITH DAVE
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May 27, 2009 – BREAKFAST WITH DAVE
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