breakfast with dave 072010

8/9/2019 Breakfast With Dave 072010

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David A. Rosenberg July 20, 2010 Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveQ&A WITH THE BEAR

Gregory Zuckerman at the Wall Street Journal just published a Q&A on the

market and the macro outlook, featuring me alongside James Paulsen, Chief

Investment Strategist at Wells Capital Management, whom I like a lot, but

basically disagree with 99% of his views. Mr. Zuckerman only had so much

space and while he did a great editing job, what I thought I would do is pass

below the full-fledged responses from my end. Enjoy!

Where is the market headed the rest of this year and over the next 12-18 months?

The market, like life and the seasons, moves in cycles — 16 to 18 year cycles, infact. Sadly, this secular down-phase in the equity market began in 2000 when

the major averages hit their peak in real terms, and so the best we can say is

that we are probably 60% of the way into it. This by no means suggests that we

cannot get periodic rallies along the way, but in a secular bear market, these

rallies are to be rented, not owned.

In contrast, corrections in a secular bull market, as we saw in 1987 (as scary as

it was) are opportunities to build long-term positions at more attractive pricing.

In secular bear markets, the indices do hit new lows during the recessions (ie,

2002, 2009), when they occur; in secular bull markets, you do not make new

lows — they are just corrections (ie, 1987, 1990, 1994, 1998).

The market is not as cheap as the pundits, who rely on year-ahead EPSestimates, deem it to be. When one incorporates cyclically-adjusted corporate

earnings in ‘real’ terms, equities are still roughly 20% overvalued even after the

recent correction.

More fundamentally, it would seem reasonable to expect that the equity market

will trade down to a valuation level that is historically commensurate with the

end of secular bear markets. This would typically mean no higher than a price-

earnings multiple of 10x and at least a 5% dividend yield on the S&P 500. So,

we very likely have quite a long way to go on the downside.

But it will not be a straight line and there will be intermittent rallies, as we

experienced a year ago April; however, not even that 80% bounce off the lows

managed to violate any of the long-term trend lines, which continue to portray aprimary bear market, not unlike what we endured from 1966 to 1982. Back

then the principal cause was an inflationary spiral; this time it is a deflationary

debt deleveraging that is the root cause. Within the next 12 to 18 months, I can

see the S&P 500 breaking back below 900, and a substantial test of the March

2009 lows cannot be ruled out.

Please see important disclosures at the end of this document.

Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net worth 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,

visit www.gluskinsheff.com

• A meat-grinder market: typically, what happensafter a once-in-a-

generation-type declineare powerful rebounds, butit never moves in a straightline

• Tough slog foremployment: a survey byAccenture showed thatbusinesses in the U.S. donot plan to restore theirworkforce to pre-recessionlevels anytime soon

• The roof collapses on U.S.housing: the NAHBhousing market indexcaved in again in July

• The U.S. equity market isstill overvalued, according

to the latest Shiller P/Eratio reading

• What could happen that

would turn you into abear/bull?

• How will the U.S. mid-termelection affect stocks, if atall? Tax rates on incomeand capital are going upnext year, and gridlock willnot give us strong leadership — hardlypositives for the economicor market outlook

• An interview with the Bear:Gregory Zuckerman at theWall Street Journal justpublished a Q&A on themarket and the macrooutlook, featuring mealongside James Paulsen,at Wells CapitalManagement, whom I like

a lot, but basicallydisagree with 99% of hisviews

IN THIS ISSUE



July 20, 2010 – BREAKFAST WITH DAVE

What about the outlook for the U.S. and global economy?

I strongly believe that the economic recovery phase is behind us. Even if we

manage to avert a double-dip recession, the chances of a growth relapse in the

second half of the year are higher than the equity market, and to a lesser extent

the credit market, have priced in. Treasuries seem to be the asset class that

most closely shares my cautious views. Anyone with a pro-cyclical bent has to

answer for why it is that the yield at mid-point on the coupon curve is below 2%,

a year after a whippy rally in equities and commodities and what appeared to be

a sizeable policy-induced GDP jump off the bottom.

Given the unprecedented massive government intervention across the planet, it

can hardly come as a surprise that economic activity began to recover exactly a

year ago. But when the equity market was hitting its recovery highs in early

spring, it reflected a widespread view that the green shoots of 2009 would be

extended into a sustainable growth phase into the future. Not a good

assumption then; and not one now.

All of the optimism that dominated the marketplace over the past year

overlooked a significant fact. While U.S. banks have recapitalized themselves

and written off debt, this cycle has been dominated by governments socializing

the losses and taking the bad debts from the private sector and transferring the

liabilities to the public sector balance sheet. The debt problem was merely

shifted from the private sector to the government sector.

The Greek sovereign debt crisis has acted as the proverbial canary in the coal

mine, underscoring the view that governments have probed the outer limits of

their deficit financing capabilities. This has important implications for the

economic outlook since the recovery has really been one part bailout stimulus, to one part fiscal stimulus, to one part monetary stimulus, to one part inventory

renewal. Now that the boost to growth from the inventory bounce has run its

course, the stimulative effects of fiscal policy will diminish in coming quarters as

the public backlash against further increases in the debt-to-income ratio

constrains the government’s ability to continue to try and fine-tune the economy.

The dramatic government incursion into the macro landscape and capital

markets obscured the fact that the economy is still in the throes of a multi-year

credit contraction phase and as such what we can expect is for the pace of

activity to weaken substantially during the periods when the stimulus fades.

This is what we can expect in the second half of the year and into 2011 when

tax rates rise substantially for many Americans.

Even if we don’t get a double-dip recession, and I think at a minimum what we’re

going to get is a 2002 style growth relapse when GDP growth converges on final

sales somewhere around a 1% rate; the consensus right now is for a 3% second

half growth, which is right where it was heading into the second half of 2002.

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Even if we manage to avert adouble-dip recession, the

chances of a growth relapse in

the second half of the year are

higher than the equity market,

and to a lesser extent the

credit market, have priced in

The dramatic government

incursion into the macro

landscape and capital marketsobscured the fact that the

economy is still in the throes

of a multi-year credit

contraction phase




The difference of course is back then the Fed had had room to cut rates 75

basis points, President Bush had the fiscal flexibility to cut taxes dramatically

and we went and started a war, which is always reflationary. We don’t have

these outlets today.

Bad government short-term

decisions over good long-term

solutions are burying the world

into a graveyard of debt

Moreover, whatever pace of economic activity we see, I am sure that it will be

insufficient to absorb the still-large amount of excess capacity in the system. In

turn, what this means is that the U.S. unemployment rate will stay near double-

digit terrain for an extended period of time. It also implies that inflation and

interest rates will remain low for a sustained period of time, and, that a stock

market priced for peak earnings in 2011 could be in for some pretty big

disappointment.

As for the global economic outlook, the bloom is off the rose as well. The OECD

leading indicator in May turned in its softest pace since the depths of despair in

March 2009. China’s massive stimulus program has run out of steam and the

government has been tightening policy this year to redress substantial over-

investment in real estate and what may well be an unsustainable price bubble.

At the very least, China is unlikely to be the engine of global growth to as great

an extent as it has been. Much of Europe is in massive fiscal retrenchment

mode, and the peaking out in commodity prices will also have dampening

effects on the resource-producing countries, particularly in the once-hot Latin

American economies.

What keeps you up at night and what worries you most about the investing environment?

Bad government short-term decisions over good long-term solutions are burying

the world into a graveyard of debt. People have to understand that 80% or

higher debt-to-GDP ratios are a new dynamic and a game changer in Europe andin the United States. The bottom line is that all levels of society, and across

most countries in the industrialized world, have far too much debt and far too

much debt-servicing costs in relation to income.

For the entire OECD countries, general government debt as a share of GDP

alone has ballooned from 73% when the recession started in 2007 and will

climb to a record 104% next year. It took 15 years for this ratio to go from 63%

to 73% and just four years from 73% to 103%. Total claims in the OECD at all

levels of society just broke above 360% of GDP and that is clearly unstable.

Suffice it to say, many of these debts will not be serviceable — identifying where

the defaults and haircuts take place, across countries and sectors, will require a

tremendous level of skill.

The problem of excessive debt leverage got worse in the aftermath of the

financial crisis, not better. This is what keeps me up at night — kicking the can

down the road in terms of addressing the global debt problem will only end up

making the situation worse. Governments seem to believe that the solution to a

debt deleveraging cycle is to create even more debt. But delaying the inevitable

process of mean-reverting debt and debt-service ratios back to historical norms

will be even more painful.

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There is simply no quick fix to

resolve the massive global

imbalances that were allowed

to build during the prior credit

bubble




There is simply no quick fix to resolve the massive global imbalances that were

allowed to build during the prior credit bubble. Yet, governments continue to

adopt policies that do not address problems that are highly structural in nature

and will require years of fiscal belt-tightening on the parts of consumers in much

of the industrialized world, and in the public sector as well.

What makes you most enthused about the investing environment?

We are entering into a period of stable consumer prices that should last at least

for a generation. This will help prevent erosion in real household incomes.

There is a strong probability that after years of very solid productivity gains in the

industrial sector, the U.S. will experience a manufacturing renaissance of sorts

and re-emerge as a global export leader. The move towards frugality and

savings will make us less reliant on foreign borrowings and usher in a period of

stronger household balance sheets.

Where are you investing right now? Where do you plan to invest in 2011?

What should investors do with their portfolios?

My primary strategy theme has been S.I.R.P. (Safety and Income at a

Reasonable Price) because yield works in a deleveraging deflationary cycle. Not

only is there substantial excess capacity in the global economy, primarily in the

U.S. where the “output gap” is close to 6%, the more crucial story is the length of

time it will take to absorb the excess capacity. It could easily take five years or

longer, depending of course on how far down potential GDP growth goes in the

intermediate term given reduced labour mobility, lack of capital deepening and

higher future tax rates. This is important because what it means is that

disinflationary, even deflationary, pressures will be dominant over the next

several years.

Moreover, with the median age of the boomer population turning 55 in the U.S.,

there is a very strong demographic demand for income and with bonds

comprising just 6% of the household asset mix, this appetite for yield will very

likely expand even further in coming years. Within the equity market, this

implies a focus on squeezing as much income out of the portfolio as possible, so

a reliance on reliable dividend yield and dividend growth makes perfect sense.

We are in a period of heightened financial market volatility, which is typical of a

post-bubble deleveraging period when the forces of debt deflation are countered

by massive doses of government reflationary polices. This to-and-fro is the

reason why in the span of a decade we have seen two parabolic peaks in the

equity market (September 2000 and October 2007) and two depressed bottoms

(October 2002 and March 2009). As I have said before, 80% rallies in a 12-month span, as we saw in the year to April, last happened in the early ‘30s and

were followed by gut-wrenching spasms to the downside. So for any investor,

return of capital is yet again reemerging as a very important theme, and the

need to focus on risk-adjusted returns. This, in turn, means a strategy that

minimizes both the volatility of the portfolio and the correlation with the equity

market is completely appropriate — the best way to play this is with true long-

short hedge fund strategies.

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My primary strategy theme has

been S.I.R.P. (Safety andIncome at a Reasonable Price)

because yield works in a

deleveraging deflationary

cycle




Gold is also a hedge against financial instability and when the world is awash

with over $200 trillion of household, corporate and government liabilities,

deflation works against debt servicing capabilities and calls into question the

integrity of the global financial system. This is why gold has so much allure

today. It is a reflection of investor concern over the monetary stability, and Ben

Bernanke and other central bankers only have to step on the printing presses

whereas gold miners have to drill over two miles into the ground (gold

production is lower today than it was a decade ago; hardly the same can be said

for fiat currency).

Moreover, gold makes up a mere 0.05% share of global household net worth, so

small incremental allocations into bullion or gold-type investments can exert a

dramatic impact. Gold cannot be printed by central banks and is a monetary

metal that is no government’s liability. It is malleable and its supply curve is

inelastic over the intermediate term. And central banks, who were selling during

the higher interest rate times of the 1980s and 1990s, are now reallocating

their FX reserves towards gold, especially in Asia.

HOW WILL THE U.S. MID-TERM ELECTION AFFECT STOCKS, IF AT ALL?

Call it a mixed bag. First and foremost, we will probably experience political

gridlock in the U.S. at a time when the country desperately needs strong

leadership. On the positive side, however, we may well see the return of the two-

party system, and so the populist anti-business sentiment in Washington is likely

to subside.

Whether or not President Obama can move to the center as Bill Clinton did after

the 1994 mid-term defeat remains to be seen, but no matter what happens, we

are not going to have Ronald Reagan or George W. Bush to kick start a new bullmarket with major tax relief. Regardless of the outcome, tax rates on income

and capital are going up next year, and gridlock will not give us strong leadership

— hardly positives for the economic or market outlook.

WHAT COULD HAPPEN THAT WOULD TURN YOU INTO A BEAR/BULL?

A new “killer app” or some major technological breakthrough would be nice.

A sustained decline in oil prices that is induced by new supplies as opposed to

demand destruction would act as a de facto tax cut.

Structural economic reforms in the world’s “surplus saving” countries, such as

China, India and Germany, that stimulate their domestic demand and hence

bolster our exports and reduce the global reliance on the U.S. as the consumerof last resort would be a huge plus.

Signs that the debt deleveraging cycle has run its course. Progress in terms of

working our way through the domestic balance sheet repair process among

households and businesses, though history shows that this not merely a two or

three year adjustment following a credit bubble and ensuing financial on the

scale that we have just endured.

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Regardless of the outcome of

the mid-term elections in the

U.S., tax rates on income and

capital are going up next year,

and gridlock will not give us

strong leadership




STILL OVERVALUED

The latest Shiller P/E ratio continues to point to a market that is overvalued.

At the most current reading of 20.1x, the S&P 500 is 23% overvalued (relative

to the long-term average), up slightly from the 21% overvalued reading in June.

In fact, on this basis, July marks the ninth consecutive month that the S&P

500 has been overvalued by 20% or more.

What will it take to get the market back to fair value? For the Shiller P/E to

mean revert to the long-term average of 16.4x, we would need to see a sell-off

of about 170 points, to 900 on the S&P 500.

THE ROOF COLLAPSES

The National Association of Home Builders’ housing market index caved in

again — sliding to 14 in July from 16 in June and 22 in May. This was not just

well below the 16 consensus guestimate, but was a fresh 15-month low —despite the lowest mortgage rates on record. The vagaries of a post-bubble

credit collapse — time to tear out some of those chapters from the Econ101

textbooks. In a credit cycle, interest rates matter far less. The “buyer traffic”

subindex was truly abysmal — down to 10 from 13 in June. Back in March

2009, at the depths of the recession, this metric was sitting at 9.

Are we now seeing brown shoots? The answer is a resounding yes. Each of

the past 16 U.S. economic data releases have come in below expectations.

That goes back nearly a month — maybe that’s why the U.S. dollar has been

taking it on the chin. Not even Europe or Japan has a losing streak that long.

In fact, taking June and July together, about 70% of the incoming indicators

have been below consensus estimates. By way of comparison, about 70% of

the indicators were surpassing expectations back in April, which may well helpexplain why that was the month that the stock market peaked.

MEATGRINDER MARKET

There was a really great article yesterday’s USA Today (Comparisons to the

Great Depression Keep Popping Up) on just how intense the market volatility

is in an “uncertain, post-bubble world”. Typically, what happens after once-in-

a-generation-type decline, as we saw in 2008 and into 2009, are powerful

rebounds. But it never moves in a straight line. Relief rallies are almost

always followed by big dips, which are then followed by fresh rallies and sell-

offs. Perpetual motion, and yet no positive returns, unless you sell in time (or

sell calls and collect the option premium).

To wit:

“New highs often don't materialize for years, if at all. Ten years after super-

pricey tech stocks crashed in 2000, the Nasdaq composite remains 56.8%

below its record high. Similarly, Japan's benchmark stock index, the Nikkei

225, is down 75.8% since its stock and real estate bubble burst in late 1989.

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Are we now seeing brownshoots emerging in the U.S.?

The answer is a resounding yes

Looking at the economic

indicators in the U.S., taking

June and July together, about

70% of the incoming data have

been below consensus

estimates




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Consider the aftermath of the 1929 stock market crash. After an initial drop

of nearly 48% the Dow enjoyed five bull market rallies, with gains ranging

from 23.4% to 48%, says Dow Jones Indexes. But each rebound was followed

by a sizable relapse, with declines from 37.4% to 53.6%. Each relapse led to

lower lows and the Dow's eventual record bear market decline of 89.2%. The

Dow took 25 years to hit a new high.”

Prepare for similar volatility in the future — the latest swings are a market

microcosm. After the Dow’s 53.7% drop in the 2007-09 bear market, it has

rallied as much as 71%, only to suffer a recent correction of 13.6%.

In this environment, hedge funds that actually hedge are prudent ways to

eradicate the volatility, minimize the correlations, and allow for respectable

real risk-adjusted returns that staying in cash just can't provide.

TOUGH SLOG FOR EMPLOYMENT

A just-released survey by Accenture showed that businesses don’t plan to

restore their workforce to pre-recession levels anytime soon. Of the 313

companies polled that reduced staff during the prior 12 months, 44% stated

that they do not intend on rebuilding their work force to pre-recession levels.

About 20% said they definitely would not, while 35% said they would fully restore

headcount in no more than two years.




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