breakfast with dave - january 25 2010

8/14/2019 Breakfast With Dave - January 25 2010

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January 25, 2010 BREAKFAST WITH DAVE

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MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

The tone to the equity market is kicking off the week in much better form than

was the case as last week drew to a close Asia was held to a modest loss of

0.7% (sixth decline in a row the Hang Sang has now corrected 10% from the

nearby November highs) and European marts and S&P futures are solidly in the

green. Bonds are giving back part of last weeks yield decline. In classic risk-

appetite style, the Japanese yen is weakening (there is talk of the BoJ expanding

its QE program) and the commodity currencies are f irming after last weeks

drubbing. It looks the DXY is sputtering now at the 200-day m.a. and the gold

price seems to have again successfully met support at the 100-day m.a. line.

The market chatter this morning is that Bernanke will be reappointed so perhaps

this will part one cloud, though we do see that corporate bond risks are on the

rise in Europe as per the widening in credit default swaps.

On the data front, not much to report. German consumer confidence came out

for January and fell for the fourth month in a row. As far as the week ahead is

concerned, we are going to be littered with U.S. housing data (see Housing Data

Fail to Fulfill Hopes of a Broad Recovery on page 2 of todays FT), the FOMC

meeting on Wednesday, and the Davos meeting summit begins on Wednesday

too.

As an aside, Bank of Canada Governor Mark Carney is interviewed on page 14 oftodays Financial Times with frank answers to some tough questions. The

preamble to the interview makes the point that Canadas financial system

remains healthy and also makes the point that Mr. Carney had extensive

private sector experience before taking over at the helm at Canadas central

bank (unlike most of his contemporaries). Makes you damn proud to be a

Canadian!

MARKET ANGST

As we had suggested, 2010 was not going to be another year of the rising tide

lift ing all the boats this has become a much more discriminating market where

investors now are not merely focusing on whether companies are beating their

estimates but also what is happening underneath the hood (Google, for

example, disappointing on the revenue line).

We closed the week with a really bad session for the S&P 500 down 2.2%,

worst day since October 30/ 2008. And not just Friday, but the three-day decline

of 5.1% was the worst move since March 9th, 2009 when the market was

plumbing the depths. But think of how things have changed since then. There

are no more shorts to cover. The banks are no longer receiving benefits from

IN THIS ISSUE

Equity markets on astronger footing and bondyields giving back part oflast weeks decline.

On tap this week: lots ofUS housing data, FOMCmeeting (Wednesday) andthe Davos submit.

Last week was a really badsession for the S&P 500and we saw the VIX jumpnearly 30%.

Q4 earnings season is infull swing this week. Sofar, earnings results havebeen good (tracking 193%YoY) but revenues havelagged.

On the US political front,two days after theDemocrat defeat, Obama

begins an assault on thebanking sector.

Pundits are assigning a60% odds for Bernankesreappointment.

Another five banksshuttered their doors lastweek and the latest Feddata show credit

contraction continues.


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the government. The room for fiscal largesse is far lower than it was then. The

ability for the Fed to ease monetary policy is far more constricted too.

And while we may have a recovery of sorts in production and sales, again

courtesy of government intervention and a short-term inventory adjustment, real

income and employment are still in decline. This is a recovery with one arm and

one leg and Mr. Market may have celebrated the onset of economic expansion a

litt le too exuberantly, with that 70% bear market rally off the lows. This

correction, by the way, has a completely different feel to it than the blip-down

that we saw last July we are witnessing the first major short-term move down

since those March 9th lows. And dare we say, this has a September 1987 feel

to it except the economy was on solid footing back then.

Note that all three major averages have incurred some major technical damage

and all are trading now below their 50-day moving averages. The fact that

investor optimism just reached a two-year high just as the market was cresting

(according to a Reuters/ University of Michigan survey) suggests that there is still

more air under this market that can be let out over the near and intermediate-

term. Every step of the way in the past nine months, selloffs in equit ies were

being treated as buying opportunities which means the action in the next few

weeks is going to be key. Watch the charts.

The VIX took a really big jump to close out the week as the complacency got

shaken out of the market this fear gauge popped up 30% over the week but

even at 23%, it is still below its 26-week moving average and basically merely in

line with the average of the past decade. More room to run on this score. But

make no mistake investor nerves are being put to a critical test for the first

time in a good while. That 55% jump in the VIX in the last three sessions of thepast week was the largest run-up since February 2007 open interest for calls

on the VIX stands at 1.66 mill ion versus 524,108 put contracts and volume to

close out the week was triple the norm. VIX futures are also currently trading

above 25% as investors are placing bets that in this new era of policy confusion,

heightened market volatility is to be expected.

EARNINGS UPDATE

Its st ill relatively early in the Q4 earnings season, with about 20% of S&P 500

companies reporting. Well have a better view on Q4 earnings after next week as

130 S&P companies and 12 Dow companies report.

On the surface, earnings results have been strong with a blended earnings

growth rate at 193% year-over-year, up 9 percentage points over the past week,and 11 percentage points from the start of reporting season (according to

Thomson Reuters). But the headline is a tad misleading. Outside financials,

which are bungee jumping off a super-depressed base of a year ago earnings,

are tracking 9% YoY.

So far, nearly 80% of companies that have reported have beat expectations,

which is significantly above the long-run average of 60%. On average,

Weve seen somecomplacency shaken outof the market with the VIX

jumped 30%last week.Even so, current levelsremain below its 26-weekm.a.

The U.S. corporateearnings season is in fullswing this week with 150companies reporting. Sofar, earnings results have

been great (+193%YoY)


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companies have beat analyst expectations by about 21% (long-term average is

2%).

While earnings have been strong, revenue results have lagged. On this basis,

the blended rate is 5% year-over-year, which is lower than last weeks rate of

7%. Once Financials are stripped out, revenue growth is sitting at the grand

total of 0% -- down a percentage point from a week ago even as bottom-lines

improved. The question going forward is how much more companies can cut

costs at some point sales need to increase in order to increase earnings(have

a look at The Great Corporate Pullback on page B2 of todays WSJ). We have

likely reached that point, and investors can sense it.

In terms of sectors, Financials, Materials and Consumer Discretionary have the

highest earnings growth (although Howard Silverblatt at the S&P cautions that

the Financials sector is fraught with pro-forma, restatements and membership

changes). Energy and Industrials have the lowest growth rates (-24% and -13%,

respectively). On the revenue side, outside of the Financials sector huge 73%

increase (which is actually 10ppt lower than last week), Health Care is the top

sector with +9% expected revenue.

POLITICS, BUT NOT AS USUAL

So here is what is happening on the U.S. polit ical front. No more than two days

after the Democrat defeat in Massachusetts, the President begins a full-scale

assault on the banking sector. On the one hand, the policymakers want the

banks to start lending money; and on the other hand, they want the banks to de-

risk their activities. The banks obviously didnt help their cause with a lack of

contrition and by sanctioning a bonus boom during these difficult times afterhaving been saved by the taxpayers pocketbook, but the Obama attacks on the

banks are very likely going to do more harm for the economy than good but

then again, this is an Administration that never did have an economic vision and

has so far decided to fight the prolonged period of post-bubble economic

malaise with a string of short-term quick fixes with no multiplier impact on job

creation and no long-run productivity benefits.

The fact that Ben Bernanke, despite all his faults, is now at risk of not being

reconfirmed is another part of this blame game. As if Don Kohn is going to do

a better job? He was there at the Fed throughout the entire Greenspan and

Bernanke era in any event. And of course, it looks like both Geithner and

Summers have been pushed aside because their proposals were largely aimed

at invoking change in the banks behaviour by using a carrot instead of a stick,and here we have the President bypassing his own team and taking the advice

of Paul Volcker (even calling the changes back to Glass-Steagall as the Volcker

Plan) after ignoring the legendary former Fed Chairman for most of the past the

year. Confusion reigns.

Two days after theDemocrat defeat, Obamahas begun an assault onthe banking sector. Policy

makers want banks to de-risk their activities but atthe same time startlending money.

.But S&P 500 revenueresults have lagged. Howmuch more can companiescut costs? Sales will needto increase in order to seeearnings growth in thefuture.


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he is not reappointed by January 31st, then Vice-Chairman Don Kohn would take

over as Chairman; Bernanke could, if he so desired, stay on as Governor, since

his term does not expire until 2020 (but why would he want to stay on as part of

this circus?).

CREDIT CONTRACTION IS ONGOING

To litt le fanfare, regulators closed five banks on Friday, bringing the failure toll in

2010 to nine. Columbia River Bank, The Dalles, Oregon; Evergreen Bank,

Seattle, Washington; Charter Bank, Santa Fe, New Mexico; Bank of Leeton,

Leeton, Missouri; and Premier American Bank, Miami, Florida have been

closed. The credit crisis appears to be over because the government has

continued to guarantee all and any banking sector liabil ity, but it is abundantly

clear that strains are still very intense and that impaired loans are still being

squeezed out of the system.

Also, have a look at Loan Demand Raises Worry on page B3 of the weekend

WSJ. The bottom line is that BB&Ts (considered to be a strong bank) would

have seen its loan book shrink due to the absence of its purchase of the failed

Colonial Bank and its loan loss provisions surging 37% in the latest quarter to

$725 million. SunTrust saw its interest income decline 2% and posted a $248

million loss.

Moreover, the latest data from the Feds H.8 report showed further contraction

in bank lending commercial & industrial loans fell $9.2 billion in the January

13 th week; real estate lending shrunk by $5.0 bil lion; and consumer credit

declined $3.8 bil lion. The contraction in bank credit is unprecedented now

totaling roughly $600 billion or 6% since the fall of 2008.

EMPLOYMENT BACKDROP STILL SOFT

The Bureau of Labor Statistics just couldnt help us close out the week with

some good news. Instead, it released the state-by-state jobs data for the month

of December, and showed that even though the unemployment rate managed to

stay at 10% in December, the reality is that it rose in 43 states or 86% of the

country. Only 4 states enjoyed a lower rate.

In November, 36 states had posted a higher jobless rate, so the 46 states in

December is truly an alarming increase. New Yorks rate hit a 26-year high of

9% and based on what the Obama team plans to do to the banking sector, look

for even higher highs in the near future. New Jerseys soared to a 33-year high

of 10.1%. This is the recovery that economists and equity strategists have been

boasting about? Wed shudder to see what a recession looks like.

CHINA GETS ALL THE PLAY, BUT

Its really India that has the long-term demographic advantage. This is true in

terms of future population trends, as well as the fact that India also has twice as

many people that can be classified as middle class at 300 million

strong. Income fundamentals are also far stronger. For a good take on the

differences and why Asias true shopping powerhouse resides in India, and not

Another five U.S. banksfailed last week (year-to-date tally is up to 9). Ontop of this, latest datafrom the Fed show furtherbanking lending

contraction.

India has a long-termdemographic advantagewith a middle class that istwice as large as Chinas.


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China (where the economy is dominated by fixed-investment), have a look at

Dont Underestimate Indias Consumers page 84 of the current Businessweek.

Still, China grabs all the headlines, and now its all about how last years

massive fiscal and credit stimulus has probably worked too well for its own

good. The dark side of the countrys resounding 10.7% GDP growth rate is that

inflation is percolating across a broad front. The consumer inflation rate

accelerated markedly in December to +1.9% from 0.6% in November; and the

PPI tripled consensus expectations in December and came in at +1.7% YoY a

huge swing from the 2.1% decline in November. More policy tightening is very

likely on its way and this is why, even being secular commodity bulls, we had

become near-term cautious in recent months so as to be in position to

participate in the next inevitable up-leg but at better pricing.

Finally, Floyd Norris pens a great article on page B3 of the Saturday NYT on what

China has been doing with regard to its bond strategy (Debt Burden Now Rests

More on U.S. Shoulders). Interest ing, for all the talk about how the U.S. fixed-

income market would collapse without Chinas support, the country has actually

seen its Treasury holdings decline since July and if there has been any fallout, it

is not apparent to the naked eye because all yields along the curve have done is

move in a range (in fact, Chinese buying only represented 5% of U.S.

government-financing needs in 2009, down from 20% in 2008 and the near-

50% peak in 2006).

At no time in the past decade has China actually been a net seller of U.S.

Treasuries over a six-month span and the evidence is in: no discernible

damage to the bond market. Why is that, pray tell? Well, other countries have

picked up the slack after all, Japan owns just about as many Treasuries ($757billion) as China does ($790 bill ion). And dont forget that Chinas bilateral t rade

surplus and the U.S. trade deficit have both plunged. All the Chinese buying of

U.S. Treasuries ever really did was reflect what Americans were buying from

Chinese manufacturers (i.e., all this focus on the Chinese buying of our

Treasuries was nothing more than how they were getting paid to sell their

products into the American marketplace which is why this notion that China

could ever unilaterally decide to dump its Treasury holdings never made any

sense. The fact that China owns so many U.S. securities is because the U.S. is

the largest buyer for its cheap consumer goods. Its an accounting identity right

out of Economics 101 in which the capital account has to equal the current

account).

FISCAL STIMULUS ...ALMOST LAUGHABLEWhat seems to get lost in all the chatter out of Washington about the coming

fiscal spending is just how intense the f iscal drag is going to be coming out of

the state and local government sector. See page 13 of the Sunday NYT Tax

Increase For the Rich Is at Issue In Oregon. Voters in the state will decide

tomorrow whether or not the state will move to implement a tax boost for higher-

income residents and on businesses in to help defray the cost of education and

other public services.

Japan owns just as manyTreasuries as China does.


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Gluskin Sheffat a Glance0Gluskin 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 andremains 65% 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 $15.5 million2

onSeptember30, 2009 versus $9.7millionfor the 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 $11.2 millionusd

2on September 30, 2009 versus $8.7

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

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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.

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Our success has often been linked to ourlong history of investing in under-followed and under-appreciated smalland mid cap companies both in Canada

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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

$15.5 million2 on

September 30, 2009versus $9.7 mil lion for the

S&P/TSX Total Return

Index over the same

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HHHHHHHFor further information,

please contact

[email protected]

Notes: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 informat ion 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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Neither the information nor any opinion expressed constitutes an offer or aninvitation to make an offer, to buy or sell any securities or other f inancialinstrument or any derivative related to such securities or instruments (e.g.,options, futures, warrants, and contracts for differences). This report is notintended to provide personal investment advice and it does not take intoaccount the specific investment objectives, financial situation and theparticular needs of any specific person. Investors should seek financialadvice regarding the appropriateness of investing in financial instrumentsand implementing investment strategies discussed or recommended in thisreport and should understand that statements regarding future prospectsmay not be realized. Any decision to purchase or subscribe for securities inany offering must be based solely on existing public information on suchsecurity or the information in the prospectus or other offering documentissued in connection with such offering, and not on this report.

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breakfast with dave - january 25 2010

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