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Inflation Reviving?Dave Rosenberg Digs Into Data, Finds Better Growth & Wage Pressures Lurking

Its taken a little getting used to, the transformation,

last year, of Gluskin Sheff Chief Economist David

Rosenberg from one of the Streets most prominentbears a perma-bear in the eyes of many to

the bright side, so to speak. (If thats how you want

to look at someone generally bearish on bonds and

bullish on stocks.) Not that Dave is ever really a

perma-anything, of course. The epitome of an inde-

pendent professional, he simply calls them as he

sees them. Dave cant help it if people, even clients,

do tend to want to put him in a style box.

He leaves it completely up to his many faithful read-

ers to deal with how comfortable or uncomfort-

able his calls make them.

Recently, Dave has been writing about economic

growth this year that he thinks will surprise a lot of

people on the upside, and a mild pick up of infla-

tion, as well one that could upset any number of

complacent investment assumptions. Fine gentleman

that he is, Dave generously shared those ideas with

me when we spoke Wednesday. Listen in.

KMW

Dave, you penned a piece recently conjur-

ing inflation back from the dead. Really?

DAVID ROSENBERG:

If there is a universal viewout there, it is that inflation is dead. I would agreethat it is comatose. But Im not so sure that infla-

tion is ever really dead, and I think its a mistake toforecast the future based on whats happening in

the present. Thats, I think, what gets economistsin trouble. We are very good at forecasting the pre-sent and describing the past, but we really get paid

to look in the crystal ball and forecast the future.

Which is why its bad form to call that

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mission impossible, I guess.

All I can say is that the level of complacency overinflation is palpable, whether youre a bull or a

bear. The market bulls love low inflation becauseit allows them to forecast P/E multiple expansion,and justifies their constructive view on equity valu-

ations.

The bears love not justlow inflation but defla-

tion, because it justifiestheir negative view ontop-line growth and risk

assets, and validatestheir constructive stance

on the long-durationbonds. I dont remem-

ber a time where thegeneral view on inflationwas as universal as it is

now, which is that itdoesnt exist, nor will it

for the foreseeablefuture.

Id have to agree,

except that when you try to find it, other

than in college tuition, inflation is pretty

darn hard to find.

Maybe people arent looking in the right places.For example, if you look at the combination of

rents, health care services, energy and food, Icould point to over 60 percent of the CPI thats

probably going to be showing some surprisinglyhefty inflationary numbers ahead. I know thats

really not in the market, but the apartment vacancyrate in the past year has gone from 5 percent to 4percent. Keep in mind that 30 percent of the CPI

is related to rents, whether its directly or indirectlythrough the housing measures imputed rents.

Unless somehow the

laws of supply anddemand have bypassedthe rental market, Iexpect that to be a

source of inflation.

Then too, somebodywould have to convince

me that Obamacare isnot going to be a sourceof higher health care

prices. Id like to seethat model. Thats

another, call it 10 per-cent of the index. Im

not that visually chal-lenged that I cant see

$100-plus oil and $5 anMCF natural gas. It seems to me that thats alsogoing to be adding to inflation.

And, between the drought in California and the

drought in Brazil, whether youre looking at coffee orcorn, food prices are going to be going up, as well.

Some people might want to point to this as a shock to

This general view

of inflation

staying low

is going to be

put to the test

over the course

of the next severalquarters.

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Page One Illustration

By Victor Juhasz

juhaszillustration.com

Unemployment rates by various worker groupings


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incomes, if we just dontkeep up, but I think that

this general view of infla-tion staying low is going tobe put to the test over the

course of the next severalquarters.

You didnt evenmention college

tuitions.

Well, more fundamental-

ly, the retailers are deal-ing with their excess

capacity problems. Wejust saw Radio Shack

announcing plans toshutter 1,100 stores.

Labor costs are nolonger falling in China.In fact, productivity-

adjusted wages there areincreasing at over a 10

percent annual rate. SoChina is not the source of deflation that it used to

be.

The U.S. dollar is no longer firm, so it wont act as

a safety valve for lower import prices going for-ward, and theres no 1990s-style productivity revo-

lution on the horizon to provide cover for futurewage acceleration, which, assuredly, is going to

come as the labor market continues to tighten, by

hook or by crook. Minimum wages are rising in 34

states.

There are still an awful lot of folks who

cant find jobs, expecially full-time.

By my calculation, we have well over 30 percent ofthe sectors comprising the private sector labor mar-

ket in the U.S. basically now at full employmentlevels and seeing wage pressures escalate. As mychart [page 2] illustrates, if you were considered to

Average hourly earnings: transportation & warehousing


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be short-term unemployed (and this has a sharperrelationship with wage rates than the broader mea-

sures), the jobless rate is now below 3.5%. Dittofor anyone with a college degree. So I count nofewer than sixteen sectors that now have an unem-

ployment rate of 5% or lower covering 33 mil-lion employees or over 30% of the private sector

workforce. You already can see its impact in wagesin some sectors [Chart, page 3]. So its just a matter

of time before this all starts to show up in the

aggregate data. Growth in job availability has beenoutstripping that of actual new hirings by a factor

of two over the past year. There are now four mil-lion job openings ready to be filled that are not

being filled and if they were filled, the unemploy-ment rate would be 4% and trust me, the Fed

would be beyond tapering and the funds rate wouldbe quite a distance from zero.

You are suggesting we should just ignore

the long-term unemployed as a structur-

al issue?

The question becomes, which has a more profound

impact on wage rate determination the short-termunemployment rate, which is south of 3.5 percent,or the longer-term unemployment rate, which is

stuck well into double digits? The short-termunemployment rate actually has been proven to

have more powerful impacts on wage ranges.

I think whats happening is that the long-termunemployed and theres no question that werestill somewhere around 36 percent, in terms of the

share of the ranks of theunemployed that have

been looking fruitlesslyfor a job for over sixmonths increasingly

become unemployableand fall out of the labor

markets. Thats one of

the reasons wereexceeding 90 million onthe total number of peo-ple outside the tradition-

al boundaries of thelabor force.

But the real question is,

what sort of pressure arethese long-term unem-

ployed exerting on wagerates? The reality is, thelonger youre without a

job, the more unemploy-able you become; the

more your skill set starts to erode, and the more anemployer is simply not going to want to have a look

at you. So its a social problem. Im just not con-vinced that the number of long-term unemployed isas important an indicator of where wage rates are

going to go, as the short-term measure of jobless-ness is. And it is already back to where it was

before the last recession started.

So you see high long-term unemployment

co-existing with wage inflation?The question is, why arent these people finding a

job? Why are we seeing two people leave the laborforce for every new job thats being created? Part

of it is a demographic change: the Boomers firststarted retiring in 2011 and there are going to be

1.5 million of them turning the ripe old age of 65each and every year for the next 15 years.

But theres also an acute skills mismatch problem.The number of job openings in the past year has

actually risen more than 10 percent. If those 4million jobs were somehow to be filled, then the

unemployment rate would no longer be 6.5 percent.It would be down to 4 percent.

So whats keeping the evident lid on wage

pressures?

I think whats really masking the aggregate statis-tics is that you do have one very important sector

called financial services, where, unless youre theCEO, pay packets are getting a lot smaller [Chart,page 4]. When you consider how large the finan-


WOWS 2014

Issue Dates

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Average hourly earnings: financial activities


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cial services sector is, its pretty easy to understandthat were still feeling substantial overall wage

compression.

Its never good news when a chart points

straight down to the lower right espe-

cially considering were employed in this

sector. Need I mention whats been hap-

pening to overall employment here, too?Your readers are well aware. Were seeing that inthe ADP data. Look, at some point we will bevaluing financials like regulated utilities.

Yikes!

It probably comes down to human behavior, butweve got to be very thoughtful about how far you

want to regulate the part of the economy that gen-erates a lot of the credit creation if you want to

keep the spigots open for economic growth. Yes,we had the crisis, but like anything else, afteryouve had an eight-car pileup at the corner, the

next thing you know, there are 12 stoplightssnarling traffic in the vicinity. Financial services,

which was a growth leader for so long, now is reallyin hunker-down mode, for a variety of reasons. But

lot of them are regulatory.

Yet I could argue very little substantive

has changed.

Well, I dont know. We probably, at this point, have

more compliance officers and lawyers than creditofficers. Certainly, when you take a look at money

velocity, which is really the return the Fed is getting

on its massive monetary creation, the banks havebeen extremely stringent in terms of credit growth,

given the amount of reserves that have been pumpedinto the system, and given how vast the improvement

has been, in terms of consumer credit quality, albeitoutside of student loans. The banks have been

incredibly tight-fisted.

Why take risks, when they can earn guar-

anteed, albeit tiny, spreads?

Look. When push comes to shove, what the banks

have to hold in capital against their assets has cer-tainly changed, and that is affecting their ability

and willingness to engage in a normal credit cycle.Theres no question about that, and that, of course,is showing up in their own businesses and showing

up in employment and compensation trends except for those in the C-suite.

Ill say. But the banks didnt really have

lots of credit officers leading up to the cri-

sis. They were using algorithms to gener-

ate the paper they fed into massively

leveraged derivatives.

That much is true, but look, theres a lot of blameto go around. Finance is an industry that has to be

regulated. But the risk is were swinging the pen-dulum too far the other way, from not enough regu-lation to over-regulation. Maybe thats part of the

mean-reversion process, but, the reality is that theFederal Reserve, basically, created these super-

banks. Then came the crisis. We created the WildWest with no sheriff in town, and when you create

the Wild West without a sheriff in town, you ulti-mately get a shootout at the O.K. Corral.

Thats exactly what happened. The regulatorseither abdicated their responsibilities or they did

not understand the risks. Its pretty clear in retro-spect that the big banks CEOs did not understand

the risks. But at the government level, the underly-ing assumption was that the CEOs understood therisks. So there was culpability all the way around.

You argued earlier that not much has changed.

But certainly the banks attitudes towards creditcreation and how to assess risk have changed.

That whole era of the no-doc loans, low-doc loans,NINJA loans (no-income-no-job-no-assets loans) is so over. If you dont have a great credit record,

you have to have a pretty sizeable down payment toget a home mortgage from a major bank today.

Granted, thats one area where the pendu-

lum seems to have done its swing-too-far

thing.

And one reason why growth is as tepid as it hasbeen is because we are going to be having lesscredit growth to support the pace of economic

activity than we got accustomed to during thosephenomenal baby boom-dominated years of the

1980s, 1990s, and the last cycle. The credit cyclehas certainly been altered, I would say, semi-per-

manently.

That doesnt cause me to be bearish. Im probably

more optimistic now than I was before, but I dounderstand that there are constraints on growth

going forward, and the change in the contours of

the credit cycle is one of them.

Ironic isnt it, the big banks have never

been bigger, but they are offloading more

fundamental credit creation than ever

before to for lack of a better term

shadow banks less regulated financial

organizations.

The major banks are losing market share to savingsand loans and credit unions. Whats now called P-


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to-P, or peer-to-peer, lending is also a burgeoningindustry. So there are other avenues now extend-

ing credit to households and small businesses. Butthe reality is that the days of getting 100 percentloan-to-value ratio mortgages are over. It was that

parabolic credit expansion in the last cycle thatprovided so much of that artificial prosperity.

That points to less pronounced rates of growth inthe economy, in this post-financial crisis era, butprobably more stable growth. Probably more mod-erate growth, but probably less volatile growth, too,

Not a bad trade, it would seem. But you

actually see growth picking up a tad?

Im probably a little more optimistic than the con-

sensus for this coming year, which is around 2 to2.5 percent growth. Id be closer to 3 percent,

maybe even a bit better than that, by the time wefinish off the year. It hasnt just been the winterweather holding us back so far, but a lot of the fis-

cal drag, which is easing and I think were going tosee accelerating wage trends.

And an upside growth surprise is why

youre no longer a bond bull?

Thats part of it. I was a bull on bonds for threedecades, and very much in that disinflation camp,

as we had mean-reversion. We had a dramaticrun-up in yields from, call it, 2.5 percent in the

early 1950s to 15 percent in the early 1980s, andit was very clear to me that mean reversion, dis-

inflationary momentum, was going to cause us to

go back down to roughly 2 percent of the 10-yearnote. We completed that cycle in the summer of

2012, had a failed retest of the lows last spring.But we have a new central bank policy. We have a

central bank that is no longer gunning for pricestability. We have a central bank thats already

told us it is going to tolerate inflation up to 2.5percent.

Its more like theyre gunning for inflation.

Im not saying were going back to wearing bell-bot-

tomed jeans and listening to disco music again

Thank heavens!And Im not talking about double-digit inflation,either. Thats not going to happen. But Im making

the assumption that the Fed is ultimately going toget what it wants. It might even get more than

what it wants, eventually. But this is the inverse ofthe early 1980s, to my way of thinking, when it

wasnt a good long-term strategy to be bettingagainst Paul Volcker. But it did take them fiveyears and two God-awful recessions to finally

break the back of inflation expectations. It didnthappen overnight.

You can bet against the Fed for days, months, evenquarters, but you cant bet against the Fed for

years. Volcker told you what was going to happen.Some people didnt believe him, but those who did,

ultimately profited. Then, of course, you had Alan

Greenspan, and then Ben Bernanke, take the batonand really take the disinflation momentum towardsreal price stability, which is, as far as Im con-cerned, what we have today.

But it wont last?

What we have today is not what were going tohave in the future. You dont have a central bank

saying, Weve achieved the Holy Grail. Wevegoing to keep it here. No. Theyre telling you

that inflation is too low. Bernanke told us, onDecember 18th, at his last press conference, thatwe are committed to making sure inflation doesnt

stay too low. They want inflation to go up towards2.5 percent. That is their desire. That is low, by

historical standards, but it is not price stability.The price level doubles every 30 years, at 2.5 per-

cent compounded inflation. So in bond marketterms, the bottom line is that if Treasuries rightnow were yielding 4 to 5 percent, I would say that

incorporated an adequate inflation premiumagainst what the Fed wants.

But they are not.

Exactly. the reality is that up to the 10-year part of

the curve, you have no inflation protection. So thebond market right now, to me, is a trading vehicle.

Youve got an emerging market f lare-up here.Youve got a soft non-farm payrolls number there.

Youve got a Russian incursion in the Ukraine overthere. So, youll get these little rallies, but bonds

are just trading tools now. Not investments likethey were back in the early 1980s. Weve basicallycome 180 degrees. The bottom line is that this is

not your fathers Fed, unless your father wasaround at the same time as Arthur Burns.

So actually, it is!

So you know we will end up getting more inflation.I know its not a fashionable or consensus forecast,but, frankly, I dont care. The Fed will get the

inflation it wants, by hook or by crook throughrents, through energy, through food, through health

care, and through the wage process. It may end upbeing that we get more inflation than even I think

right now. I think were going towards 2.5 percent.It could be higher.

Are you implying the Fed should be care-

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ful what it wishes for?

Look, then-Fed Governor Ben Bernanke, in July of

2003 before he was Chairman gave a speechjust a month after the Fed took the Fed funds rate

to 1 percent. Remember, back then everybody hadthe same forecast: The economy will never recov-er. Wed just been through the tech wreck.

Through 9/11. Through the corporate malfeasance

scandals. Through Iraq War II. Deflation was theword on the tip of everybodys tongue. The Fedeven started talking about quantitative easing back

then, although they waited five years before theyembarked on that route.

I dont recall that speech as unusually

cheerful and optimistic.

Hardly. Ben laid out his models and said, Based onthis the spare capacity and our forecast, core infla-

tion is going to be 0.7 percent by the end of 2004.Now, whos smarter than Ben Bernanke? Ive nevermet anybody with a higher IQ. But the reality is that

his IQ didnt have much influence on his forecastingrecord, because by the end of 2004, core inflation

was not 0.7. It was north of 2 percent. So anybodywho had believed Ben Bernankes consensus defla-

tion thesis in July 2003, and so bought Fed futurescontracts and long-dated zero coupon bonds up thewazoo, would have been creamed.

I just get a sense were at a very similar inflection

point now.

That certainly says something about the

fallibility of economic forecasts.And it tells you how to behave when youre atextreme data points. In 1981, 15 percent bondyields and 15 percent inflation were extreme.

Then a year ago, call it 1.5 percent bond yields and1.5 percent inflation was another extreme.

Thats pretty easy to see in retrospect.

Trouble is, its not so easy to see it at the

time. Indeed, some expect even more

extreme numbers than last years, in this

latest go-round.

But the burden of the economist is to forecast the

future, not the present. Its like the old adage as towhy God created economists: To make meteorolo-

gists feel good about themselves. When you fore-cast the future, you have to build scenarios. So youhave a base case, which is your most likely case,

but only the most ardent fool will say that this fore-cast is ironclad. Theres no such thing as a sure

thing in this business. So you have to identify whatis your level of conviction in your base case, and

if youre wrong what are Scenarios B, C, and

D? Thats really the key towards success; what an

economist can add to the process, in terms ofwealth management. And on that score, I did find

it interesting that Ben Bernanke, at his Dec. 18press conference, used much of the same phraseol-ogy he had used back in July of 2003. I just put

that in my back pocket.

So youre implying?Look, back in 2003, bonds were not priced for even

a moderately inflationary environment, but they gotrepriced that way. The 10-year note went from 3 to

5.35. Core inflation got as high as 3 percent, andtotal inflation got as high as 5. This time around,the starting points are even lower and the level of

complacency out there

Ergo, inflation likely will exceed the Feds

target?

It probably will. Inflation is a lagging indicatorand its a process in time. Its not a point in time.So this will be a competition between watching

paint dry and grass grow. I certainly am not goingto bet against the Fed getting what it wants. But

now that the consumer deleveraging cycle is over and keep in mind, one of the reasons inflation has

been so low, one of the reasons the velocity ofmoney has continued to decline, is that we wentthrough the mother of all deleveraging cycles.

We never before had a 5-year span, during which

the consumer sector pared over $1 trillion of debtfrom its balance sheet. Part of that was paid down.

Part came from adjusting amortization schedules.Part of it from walking away from debts. But how-ever that unprecedented debt reduction was accom-

plished, it was subtracting, not contributing toGDP, which of course is all about spending, not

about deleveraging.

That deleveraging is behind us now?

I think so, which means that with a lag, well findvelocity of money bottoming out. And, given the

amount of monetary creation that the Fed has engi-neered, my sense is that we then will get more

inflation than people think. As I mentioned, this is

a new view for me, after being in the disinflationarycamp for 25 years, I changed sides about 12months ago. But theres an old rule in economics:Marry your partner, not your forecast. It wont

love you back.

So true. But I know your changed fore-

cast had to rile some of your clients

A lot of my readership, people who had been andremain advocates of long-duration bonds, were nottoo thrilled with my change of view. But I read the


8/10

tea leaves, I do my homework, I dig through thedata. What I dont do is base a forecast off of mak-

ing people happy. I base it off of trying to do thema service. It works for some and not for others.But if youre an economist who has survived doing

this for three decades in the financial serviceindustry, by definition, you have a very thick skin.

And you so boldly made them even lesshappy recently by laying out why you see

essentially zero chance of falling back into

a recession anytime soon

Well, the business cycleisnt dead either, and at

some point wewill havea recession. I just dont

see it in the next 12 to18 months, so I laid outthe markers well have to

continuously assess eachmonth to update the

probabilities of a reces-sion. No probability in

my business ever zero or100 percent, but the

odds of a recession rightnow are as close to zeroas anything can possibly

be. And thats useful toknow. We can debate the

strength of the expan-sion, but as we saw last

year, you dont need rip-

ping growth to have anequity bull market.

I have to ask, what

do you need?

Having looked at what

drives the market for along time, I have to saytheres a wide gamut of

variables you have toconsider. You have to

look at the technicals,and you have to take a

look at fund flows, andmarket positioning, andsentiment, and, of

course, valuation. Butthe two really critical

determinants come downto the fundaments: The

economy and liquidity,i.e., the Fed. When youhave the Fed being

accommodative and the economy growing, youre ina bull market over 80 percent of the time.

So all clear now, but next year?

Like I said, the business cycle is not dead, but lets

take it a year at a time. The current Fed, led byJanet Yellen is certainly going to continue to taper;

theyre going to leave the funds rate close to zero for

as long as they possibly can. But I think the quidpro quo is that when it comes time to tightenmonetary policy theyre going to be a lot moreactive than they have in the past. I think in the next

tightening cycle, isnt going to happen in namby-pamby 25-base-point- increments like the last did

from 2004 to 2006. I think the Fed will be raisingrates more aggressively.

That could shock the system.

Well, it depends how much they telegraph. Butlook, every bear market and every recession, over

the past six decades, has had the Fedsthumbprints all over it. The Fed overstays its wel-

come in the tightening cycle, like it did in 07, andthen it overstays its welcome on the easing cycle,

as it did in 2003. Every time. And there is nomore powerful determinant of the future economicgrowth than the yield curve. People say to me, So

what youre telling me, Mr. Rosenberg, is therecant be a recession because the funds rate is zero

percent because, of course, bond yields cant gobelow zero percent, so ipso facto, there cant be a

recession. Im saying, Yes, thats 100 percent

right. Its not really that much different today thanit was in 2003. That was the mother of all easing

cycles, before this one, and, guess what? Theyinverted the yield curve. Go figure. I dont see

why its going to be different this time, because itnever is that much different.

So youre watching the yield curve.

Sure, the Fed funds rate is not staying where it is

indefinitely, any more than it did in the last cycle.Bond yields will not stay where they are, and at

some point I will turn bullish on the fixed-incomemarket again. That day will come just not at

these price points that we have today.

What other pulses are you keeping your

finger on?

Theres a whole list I published recently [See inset

table], but the thing to know right now is that, onthe basis of the current readings on my indicators,

theres not much reason to worry. Only one of themis telling me theres even a 30% chance of a reces-sion any time soon, and thats the ISM survey. Its


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Daves Top Ten Signs

Of A Coming RecessionThe macro and market indicators that have helped tip

off Dave to coming recessions going back in time:

1. Inverted yield curve

2. Morgan Stanley Cyclical Stock Index down more

than 10%3. Bond yield rally of at least 135 basis points

4. Commodity prices down 5-10%

5. HY spreads widen out 350bps or more

6. ISM below 50 for at least one month

7. Initial jobless claims (four-week moving average) up

75k

8. Relative strength of S&P Financials down at least

20%

9. ECRI smoothed index of -5 or worse

10. 20-point decline in University of Michigan con-

sumer sentiment.

Where Are They Now?The latest readings on these indicators and the not-

great odds Dave puts on them flashing a recession

warning here.

1. The spread between the 10-year T-note and three-

month T-bill yield is 265bps. Odds: 0%.

2. The Morgan Stanley Cyclical Stock Index is down 1%

from the nearby high. Odds: 10%.

3. Bond rally thus far has only been around 30bps.

Odds: 20%.

4. Commodities just hit a nearby high. Odds: 0%.

5. HY spreads have tightened to the lows for the

cycle. Odds: 0%.6. ISM is now at 51.3 (This is one to keep an eye on.)

Odds: 30%.

7. Claims are up 6k from the recent lows but remain

close to the low end of the range. Odds: 5%.

8. Relative strength of S&P Financials is down 5%

from the recent highs. Odds: 25%

9. ECRI smoothed index is now standing at +2.5. Odds:

10%.

10. UofM sentiment has only come down three points

from the recent peak. Odds: 10%.


9/10


latest reading of 51.3 is something to keep youreye on. The others are no where close to signalling

a recession where youd have to make a fundamen-tal asset-mix shift. Ultimately, it will be liquidityand the fundamentals that dictate that.

Still, weve recently seen a bit more

volatility in the markets and in interna-

tional affairs than many evidently wereprepared for. Theyre not causing you any

sleepless nights?

Like I said, my first step is identifying whether we

are in a recession or an expansion. If its anexpansion, then you do the work, top-down, bot-

tom-up, on what the economic numbers are reallygoing to look like in the expansion phase. You do

the same for the stock market. Of course, valua-tion and sentiment act as constraints. In the final

analysis, liquidity and the fundamentals will winthe day, but valuation, technicals and sentimentwill limit what you can achieve. Its nothing we

havent seen before.

Whos counting?

Well, I had the benefit of starting in this business

on Oct. 19, 1987, Black Monday, and that was alearning experience in its own right, from a wholebunch of perspectives.

I remember that end-of-the-world feeling

only too well.

We had sentiment out of control, a negative techni-

cal picture, an overvalued stock market, and that

produced a huge correction. It didnt turn out tobe the start of a bear market, though. That taught

me that you can certainly have sentiment and valu-ations and technicals give you a heads-up as to

whether to start buying some insurance, throughthe options market, or raising some cash, on a

near-term basis. But that is a very different deci-sion from predicting an outright bear market,where you really have to make a fundamental

asset-mix shift.

So youre saying, in terms of this year?

Just as the technicals, the valuation, and the senti-

ment were constraints in 1987, but we didnt gointo a bear market, they are going to be constraints,and perhaps epic constraints, this year. But that

doesnt mean were going into a bear market. Thevaluation, the sentiment, and the technicals

already have been factors explaining why this hasbeen more of a challenging market this year than

last year, when it all seemed so easy.

I guess thats why youve written that you

expect this year to be a happier one for

active portfolio management?

Yes, because the name of the game is to generate

alpha, and the correlations have come down; wevegot more volatility. So, for wealth managers whoactually have experience and expertise in buying

undervalued stocks, or who have shorting exper-tise, this will be a much better year than last year.

After all, its not supposed to be as easy as throw-ing a dart against a wall. The greater volatility and

two-sided markets weve seen this year are reallymore normal, when you think about it. Last year, a30 percent up year, with single-digit earnings

growth, so that multiple expansion had to do all ofthe heavy lifting that was unusual. Im not

complaining, it was a great year. But that kind ofyear comes around once a decade if were

lucky.

What were seeing this year, more two-way move-

ments notwithstanding the hits the emerging mar-kets are taking actually tell me that in some

senses, this is a healthier market. The volatilitywill hopefully knock some of the complacency

down a few notches it was running at such ahigh level in the last year that it wouldnt be a badthing at all.

So are you favoring any particular sectors

or themes in the stock market here?

Weve started to warm to the commodity view,

selectively.

So youre a believer in this re-emergenceof gold, for gosh sakes?

Well, its a sentiment issue. The story when it was

around $1,900 was that it was going to $3,000.Oops. Then, at the lows around $1,200, it was

going down to $850, and that was oops in the otherdirection. The truth is somewhere in between.

Gold got hit last year by a variety of negative fundflow effects Soros getting out, followed byPaulsen created a bit of a herd effect. Then you

had the import curbs imposed in India. Then, ofcourse, during that whole period, with Bernanke

talking tapering, the market started pricing in Fed

tightening and thats not usually good news for goldeither, because it reestablishes a positive interestrate premium. Not to mention that gold, going intolast year was overbought. It is a totally different

situation today.

But for more than this bounce?

I think so. Not only have a lot of the speculative

longs been driven out of the market, which is agood thing, I think that one of the principal factors


10/10

that has helped the gold sector is what I see as thisquid pro quo from Janet Yellen. Meaning she has

basically said the taper is on, and the hurdle toend the taper is very high, but what comes out the

other side is that were going to be leaving thefunds rate lower for longer.

And thats a positive for gold?

It tells a gold investor that were going to have neg-ative real policy rates for longer, and theres a verystrong correlation between negative real short-term

interest rates and the direction of gold prices. Ithink that basically gave the gold bugs the greenlight.

I expect all of the precious metals are going to do

better in that environment. I think the energycomplex is going to be doing better. Its also one of

the reasons the Canadian stock market has dramat-ically outperformed the U.S. market for the firsttime in years, in the opening months of this year.

Beyond that, I get a sense that there will be some

select industrial technology areas to invest in.

Why is that?

Because with the capital stock not having grown forthe past half decade, and with that having now trig-

gered a substantial deceleration of productivitygrowth, and understanding the link between pro-

ductivity growth and profit margins, my sense isthat were going to be getting stronger capital

spending going forward. It wont be a boom, but it

will be far better than it was, so there will be someparts of the industrial and technology sector that

will.

Its about time. Thanks much, Dave.


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