David A.

Rosenberg June 10, 2009

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

PLEASE NOTE THAT DUE TO BUSINESS TRAVEL, BREAKFAST WITH DAVE
WILL RETURN ON MONDAY, JUNE 15TH IN THIS ISSUE

• Bond market selloff and

stock market meltup look
MAJOR THEMES — BOND MARKET SELLOFF AND STOCK MARKET MELTUP overdone, in our view
LOOK OVERDONE
• The Fed to tighten?
The equity bull-run looks overdone: The S&P 500 is priced for around $75 of
operating EPS, something I don’t see occurring before 2012 (probably won’t get • Consumers hunkering
the number above $43 per share for this year). This rally has all been multiple down again?
expansion — from 15x on trailing EPS at the low to around 23x now. The market • Jeff Frankel, a member of
is NOT cheap. The latest Market Vane and Investors Intelligence surveys and the NBER’s Business
the Commitment of Traders report show that sentiment on stocks is now very Cycle Dating Committee,
believes that the economy
bullish. While the S&P 500 did kiss the 200-day moving average last week, the
has not hit bottom
index has failed to break above the January 6 intra-day high of 943.85 on a
sustained basis. If Paul Krugman is correct, then the recession ends in • Small business sentiment
September and that would ratify the March lows in the stock market. edges up in May

Be that as it may, the market is more than fully priced — what is ‘normal’ is for
the S&P 500 to rise 20% from the lows to the end of the recession — this bull-
run has been twice as pronounced. In fact, on average, we are up 40% from the
lows when the economy has completed nine months of recovery — so you see
what we mean when we say “fully priced”.

Bond selloff overdone too, notwithstanding the rush of supply (most of the
Treasury auctions have actually gone pretty well, so this can’t be all about
supply): Through a good part of the Treasury yield run-up, private sector rates
were unaffected, but now we have the 30-year mortgage rate approaching 5.5%
and mortgage refinancing activity has plunged about 60% in the last two
months. Mortgage applications for new home purchases collapsed at a 20%
annual rate in May too. The futures market is priced for three Fed tightenings;
however, historically, the Fed does not tighten and bond yields do not bottom
until after the unemployment rate peaks. Question is whether the Fed will step
up its coupon-buying program. We have already crammed into six months what
it took 48 months to accomplish in the 2003-07 bear market — to see the 10-
year yield soar 180 basis points from the low. With inflation running at -0.7%
YoY, we now have a ‘real yield’ of 4.5% — the last five times we got to this level,
the nominal yield rallied 50 basis points in the next three months. As an aside,
a 4.5% real government yield and 8.0% real corporate bond yield is serving up
some major competition for equities right now.

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June 10, 2009 – BREAKFAST WITH DAVE

The rally in the commodity sector may have run too far as well, at least over
the near-term — U.S. crude stockpiles are up around 20% over the last year and The futures market is
WTI has rallied 30%. Oil prices may have overshot to the downside at around pricing in three Fed rate
$30/barrel at the low but near $70/barrel right now looks overextended. I hikes, which is
would suspect that the Canadian dollar will prove to be similarly overextended borderline hilarious
and the BoC, I believe, is more comfortable with the loonie in the low-80s than
the low-90s.

THE FED TO TIGHTEN?

The futures market is pricing in three Fed rate hikes, which is borderline
hilarious when one considers that at 9.4% in May, the unemployment rate has
already hit the central bank’s forecast — seven months early! The San Francisco
Fed just completed a very interesting study, which found that in normal post-
WWII recessions, the share of the unemployed that are “temporary layoffs” rises
significantly, but in this down-cycle, that ratio fell a percentage point to 11.9%.
The job losses this cycle have been more permanent in nature and what
businesses have done is increasingly shift their staff to part-time work at a rate
that we have never seen before. What this in turn means is that long after the
recession ends, the unemployment rate is going to keep rising because firms will
naturally just redeploy these part-timers into full-time work and in turn that
means that the natural influx of labour force entrants are going to be taking
much more time engaged in their job search. Unless the laws of supply and
demand somehow don’t apply to the labour market — they actually do today
more than ever — we should be seeing downward pressure on wage rates for
years to come. That is the antithesis of a deflationary backdrop.

CONSUMERS HUNKERING DOWN AGAIN?

The run-up in gasoline
The Redbook survey no longer has Wal-Mart in its data bank, and what we can prices is starting to take
see excluding the huge defensive retailer is that chain store sales slid 4.4% its toll on chain store
YoY in the first week of June and running below plan. Year-ago comps are very sales
tough since the data are being calculated off the rebate-induced spike in
spending last year. Even so, it does look as though the run-up in gasoline
prices is taking its toll.

WHAT THE NBER’S JEFF FRANKEL HAD TO SAY YESTERDAY ABOUT THE
RECESSION ENDING
Jeff Frankel, a member of the National Bureau of Economic Research’s (NBER)
Business Cycle Dating Committee, which officially declares recession, believes
that “the labour market does not quite yet suggest that the economy has hit
bottom.”

“Speaking entirely for myself, I like to look at the rate of change of total hours
worked in the economy. Total hours worked is equal to the total number of
workers employed multiplied by the average length of the workweek for the
average worker. The length of the workweek tends to respond at turning points
faster than does the number of jobs. When demand is slowing, firms tend to cut
back on overtime, and then switch to part-time workers or in some cases cut
workers back to partial workweeks, before they lay them off.

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June 10, 2009 – BREAKFAST WITH DAVE

Conversely, when demand is rising, firms tend to end furloughs, and if

necessary ask workers to work overtime, before they hire new workers. (The
hours worked measure improved in April 1991 and November 2001 which on
other grounds were eventually declared to mark the ends of their respective
recessions.) The phenomenon is called ‘labour hoarding’ and it is attributable
to the costs of finding, hiring and training new workers and the costs in terms of
severance pay and morale when firing workers.

Unfortunately, as reported by Forbes, pursuing this logic leads to second

thoughts about whether the most recent BLS announcement was really good
news after all. The length of the average work week fell to its lowest
since 1964! … not only did total hours worked decline in May, but the rate of
decline (0.7%) was very much in line with the rate of contraction that workers
have experienced since September. Hours worked suggests that the hope-
inspiring May moderation in the job loss series may have been a monthly
aberration. If firms were really gearing up to start hiring workers once again,
why would they now be cutting back as strongly as ever on the hours that
they ask their existing employees to work? My bottom line: the labour market
does not quite yet suggest that the economy has hit bottom.”

SMALL BUSINESS SENTIMENT EDGES UP

The NFIB small business
The NFIB index (National Federation of Independent Business) mirrored the rise
optimism index mirrored
in the ISM and gained 2.1 points in May to 88.9, the highest level since the rise in the ISM in
September 2008 (like most other data pieces — back to where we were when May, but this just brings
the economy was nine months in recession). The internals of the index were the index back to where
also decent with six out of the 10 components rising on the month, three it was on September
components were flat and only one registered a decline. The component that 2008
had the biggest ‘green shoot’ was the percentage of firms expecting the
economy to improve, which ‘grew’ another 10 points in May on top of the
outsized 24 point ‘spurt’ in April, to stand at its highest level since September
2008 of +12. But don’t jump for joy yet; looking back in history, this metric was,
on average, at 31 when the recession ended.

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June 10, 2009 – BREAKFAST WITH DAVE

Chart 1: SMALL BUSINESSES OPTIMISTIC

ABOUT THE ECONOMIC RECOVERY
United States: National Federation of Independent Business
Percent of Firms Expecting Economy to Improve
(percent)

80

60

40

20

-20

-40
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

As for the employment prospects, small businesses are still very hesitant in
hiring workers. The percentage of firms planning to increase employment held
at -5 in May, and yes it is 5 points higher than the -10 level seen in March, but it
is still a negative which implies that firms are still shedding jobs. The jobs hard
to fill component also held steady at 9 in May – the worst reading since
November 82.

Chart 2: SMALL FIRMS ARE STILL HESITANT IN HIRING WORKERS

United States: National Federation of Independent Business
Percent of Firms with One or More Jobs Open
(percent)

35

30

25

20

15

10

5
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

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June 10, 2009 – BREAKFAST WITH DAVE

There continues to be no pricing power for small business. The percentage

of firms that are raising average selling prices remains in deep negative territory,
at -22 in May, still a record low. Some may say that there is pricing power down
the road given that the percentage of firms planning to raise prices rose to +3 in
May from +1 in April and nil in March. However, just look at Chart 3 and one will
see that this is not the case at all.

Chart 3: SMALL FIRMS HAVE NO PRICING POWER

United States: National Federation of Independent Business
Percent Planning to Raise Average Selling Prices, Net
(percent)

50

40

30

20

10

0
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Despite the anticipated improvement in the economy by small businesses,

their top concern remain poor sales — the percentage of respondent stating
that poor sales is their main concern remains high at 30% in May. They are not
worried at all about inflation, when asked if inflation was on top of their worry
list, only 3% said it was a problem — this is actually down from 4% in April and a
long way from the 20% reading we saw back in July 2008.

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June 10, 2009 – BREAKFAST WITH DAVE

Chart 4: THE SALES OUTLOOK TOPS

THE WORRY LIST FOR SMALL BUSINESSES …
United States: National Federation of Independent Business
Single Most Important Problem: Percent Reporting Poor Sales
(percent)

37.5

30.0

22.5

15.0

7.5

0.0
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Chart 5: … NOT INFLATION

United States: National Federation of Independent Business
Single Most Important Problem: Percent Reporting Inflation
(percent)

45.0

37.5

30.0

22.5

15.0

7.5

0.0
75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

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June 10, 2009 – BREAKFAST WITH DAVE

Corporate spreads may be narrowing for large companies and secondary

offerings are robust, but for small firms, access to credit is still very tight. Look
at the chart below — the credit sub-index is back to where it was in February.

Chart 6: CREDIT CONDITIONS STILL TIGHT FOR SMALL BUSINESSES

United States: National Federation of Independent Business
Percent Expecting Credit Conditions to Ease, Net
(percent)

-4

-8

-12

-16
90 95 00 05

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

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June 10, 2009 – BREAKFAST WITH DAVE
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June 10, 2009 – BREAKFAST WITH DAVE
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