This week I offer something unusual for outside the Box, in that I agree on almost all points with my friend David Rosenberg, except he tells it so much better than your humble analyst. David was the former Chief Economist at the former Merrill Lynch (ah, Mother Merrill, we barely knew ye.) and is now Chief Economist at Gluskin Sheff + Associates Inc., which is one of Canada's pre-eminent wealth management firms. Founded in 1984, they manage $4.4 billion. (For those who wonder, David left NYS to return home to Toronto. Much shorter commute time.) David looks at the recent stock market run-up, why he likes corporate bonds better than stocks, what is lagging with the consumer and a lot more. It is a very pithy read.

Have a good week, I am off to a beach in a few days, but there will be an e-letter this Friday. You are in good hands.

Your looking forward to reading with drinks with little umbrellas analyst,

John Mauldin, Editor
Outside the Box

Breakfast with Dave
by David A. Rosenberg

MARKET THOUGHTS

The Dow is coming off its best weekly performance since March 2000, and if memory serves us correctly, that month was marking the beginning of the end of the great bull market at that time. While the bear market rally has been of 1930 proportions, from our lens, that is what it remains and what is lacking in this extremely flashy runup in equity prices are: (i) leadership, (ii) quality, and (iii) volume. There were some very useful statistics in Barron's (despite the fact that the headline in the 'The Trader' column is Why the Rally Should Keep Rolling ... for Now):

• The 50 smallest stocks have rebounded 17.2% from their nearby July 10th lows, outperforming the largest 50 stocks by 750 basis points.
• The 50 most shorted stocks have rallied 17.6%, outperforming the 50 least shorted stocks by 880 basis points (over the same time frame).
• The 50 stocks with the lowest analyst ratings have outperformed the 50 with the highest ratings by 380 basis points.
• 85% of the market has already broken above their 50-day moving averages, which in some sense highlights an overbought market, but the other three factoids still attest to a low-quality rally, which is best left for traders and speculators. As tempting as it is to jump in, history is replete with examples of these sorts of short-covering rallies ending very quickly and with no advance notice from analysts, strategists or economists for that matter.

Let's put aside the conventional wisdom that the stock market puts in its fundamental bottom 3-6 months ahead of the recession ending; it actually bottoms ahead of the economic recovery. That was the lesson of 2002 -- recessions can end, but without a recovery there can be no sustainable bull market, though hopes can certainly bring on bouts of euphoric behaviour as we saw in the opening months of 2002 when the Nasdaq surged 45% and as we are seeing currently in the major averages. Japan is another great example. Its economy was out of recession 80% of the time in the 1990s and yet the lack of any sustainable recovery was largely behind its secular bear market. For a great reality check on the situation, have a read of Henry Kaufman's piece on page 37 of Barron's (A Long Road to Recovery). To wit:

"Some experts also expect the economy to get a boost from business inventory restocking. Maybe so, but most likely as a one-time event. Firms take on inventory if demand rises, if they expect higher prices and if they expect bottlenecks in the supply chain. But excess capacity is high, and there are no bottlenecks."

We also believe that the current edition of BusinessWeek is a must-read -- there were lots of good stuff in there this weekend, some of it following in Mr. Kaufman's footsteps (page 14 -- A Second Half Recovery Could be Fleeting). To wit:

"Will the upturn last? The question arises because the early stage of the recovery is going to be production-led, not demand-led ... to keep the production rebound -- and the recovery -- going into 2010, overall spending will have to pick up, and that's the big uncertainty given the headwinds facing consumers."

There is no doubt that inventories have been pared back over the past four quarters at a record rate, and that the ISM customer inventory index is running at extremely tight levels. That said, the NFIB inventory plan index remains very weak, so what we have contributing to GDP in the third quarter is a mathematical boost to the economy from a lower rate of destocking; much of this in the auto sector. To actually move towards a sustainable inventory cycle, businesses will have to see final sales revive. What businesses have done is essentially recognize that the secular credit expansion has moved into reverse and the process of deleveraging in the consumer and financial sectors is ongoing. So, what companies have done in their re-assessments is to re-align their output schedules, order books and staffing requirements in the context that there will be a whole lot less credit to support any given level of production in the future.

What is very likely going to be missing going forward is the consumer because while it is the "back end" of the economy that helps bring recessions to an end as inventory withdrawal subsides, it is the "front end" that causes the expansion to endure -- in normal cycles, that is. Historically, consumers end up adding 3.5 percentage points to real GDP growth in the first year of an economic renewal. As the economic editorial in BusinessWeek puts it, "this time, that's most likely impossible."

Indeed, any student of the 2000-2003 cycle knows that in the year after that downturn, the consumer offered little help -- contributing barely more than one percentage point to GDP growth, which was unprecedented and the cyclically sensitive spending segments exerted not one iota of positive contribution. The difference is that this 2007-2009 cycle was double the asset deflation and triple the job loss and coupled with a credit collapse, which means that it is going to take even longer for the consumer to come back this time around; the view that we have more stimulus this time around really misses the point. The government is merely substituting for the dramatic withdrawal in private sector spending and unless the Obama team manages to implement fiscal package after fiscal package, with the obvious distorting impact on the economy, the risk that the end of the recession only manages to bring on a prolonged period of stagnation is non-trivial and is not priced into the stock market at current valuation levels.

As we explain below, corporate bonds, while cyclical as well, are better suited for that sort of L-shaped economic environment.

Watch what the consumer does now that the fiscal stimulus is over for the time being. Year-to-date, total personal disposable income has risen at a 10.8% annual rate due to Uncle Sam's generosity; however, wages and salaries (60% of the income pie) have declined at a record 3.1% pace. We realize that there is a lot of hype surrounding the 'cash for clunkers', which is a nice gimmick but only with transitory effects. Besides, just how many vehicles on the road today don't get at least 18 miles per gallon; this is the eligibility criteria -- Jed Clampett's jalopy! -- See Clunkers Rebate Drives Car Sales. The chatter is that we are going to see motor vehicle sales improve to 10 million units (annualized) in July. Whoopee. The program is going to keep sales near 25-year lows.

What is important to focus on here is the 'new normal'. The 'new normal' nearly a decade ago was that 0% financing would bring in 20 million in sales (and think of all the sales that were brought forward). Today's 'new normal' is doing everything Washington can do to get to 10 million units. Has it dawned on them, or anyone else, that since 2000, the number of vehicles sold (net of replacement) rose nearly 30 million, doubling the 15 million increase in the number of licensed drivers? The over saturation of the auto market is unwinding, and this process will very likely take years.

While we are less enamored with the equity market as a whole, primarily the commodity-short U.S. averages, volatility does offer significant opportunities from a trading standpoint. For a perspective on this, have a look at Old-Fashioned Stock Picking Back in Style on page C2 of the WSJ. For the risk involved, we prefer to express our views in the corporate bond market. Unlike the stock market, which has de facto priced in a 40-50% earnings surge in 2010, there is no such hurdle or high-hope in the corporate bond market, which is still largely priced for a deep recession -- a GDP contraction of 1-2% going forward and the unemployment rate heading towards 11-12%.

Insofar as the economy does not relapse to such an extent, there is a significant cushion embedded in the pricing of the corporate bond market this time, even after the impressive rally -- from Armageddon levels, mind you -- earlier this year. While the S&P 500 was certainly priced for bad news at the March lows, with an 11x P/E multiple and a 3½% dividend yield at the time, it can hardly be said that it was priced for nearly the disaster that Baa corporate bonds were when spreads were hovering near levels (over 600bps) not seen since the early 1930s. Have a look at Bonds Look to steal Stocks' Thunder on page C1 of today's WSJ. The article cites analysis showing that default rates could hit 14% and high-yield bonds, as an example, could still generate significant returns -- and our former colleague, the legendary Marty Fridson, is quoted in the article as saying that returns could "reach the mid-teens over the next year" so long as the recession doesn't deepen (unlike equities, the downturn doesn't have to end -- just not get any worse).

FINANCIALS LAGGING

Everyone we talk to believes that a new bull market began in March when the White House and the Fed gave the large banks blanket guarantees for their survival and Congress basically instructed FASB to switch back to 'mark-to-model' accounting rules so the financials could show a profit. So the financials had their nice initial pop, but since May 6th, that is nearly three months now, they have basically done nothing. Not just done nothing, but have underperformed the market by 650 basis points. Financials do not have to necessarily lead the pack during a bear market rally, but no fundamental turning point has occurred with the financials lagging behind as they are currently. Food for thought.

Many pundits mistake a narrowing in credit spreads with some expectations that the economy is going to make a convincing shift into expansion mode. All spreads have done is go from pricing in a depression to pricing in a recession. Indeed, Baa spreads currently are still above the peaks of most prior recessionary phases. The credit crunch is far from over, even if we managed to emerge from the abyss last March. See CIT Beefs Up Tender; Chapter 11 Still Possible on page B3 of the weekend WSJ. And keep in mind that no regional bank is too big to fail, and they are failing -- seven more seized by the FDIC last week, making it 64 for 2009 thus far.

As an aside, the sectors that will likely lead the market in the future will be the ones at the forefront of energy innovation (clean-tech). And that means companies that are working on contracts with DARPA (the research arm of the Defense Department) may be worth a look -- DARPA was the pioneer behind the development of the Internet, the computer mouse, GPS and others -- see Can The Military Find The Answer to Alternative Energy?

BUT NOT THE CONSUMER

What has led the last leg of this rally has been the most discretionary of the consumer space: casinos/gaming stocks are up 44% from the mid-July lows; the homebuilders are up 30%; the automakers are up 28%; advertisers are up 20%; home furnishings are up 18%; hotel/resorts and specialty retailing stocks are up 15%. It's only a matter of time before these gains unwind if the early surveys are correct that this may well go down as the weakest back-to-school shopping season on record. It is seriously tough to square the bounce-back in these sectors when you take a look at where consumers are pulling back the most -- discretionary spending items. See Videogame Makers Can't Dodge Recession on page B1 of today's WSJ for just one example. The article below also serves as a commentary on how spending patterns are changing -- penny-pinching and nickel-and-diming are both in vogue (see Organic Foods Get on Private-Label Wagon).

The consumer shift away from vacations towards 'staycations' is forcing hotels to cut their room rates at a record pace -- have a look at Starwood Offering Up To 50% Off Some Rooms on page 2B of the USA Today. In addition, the airlines are now raising their baggage fees to make up for the decline in passenger volumes (there is a take on this on page 1B of the USA Today). It seems as though as smoking is the only habit that is not dying, and the tobacco producers are actually raising their prices successfully (see Tobacco Lights Up on Premium blend on page C10 of today's WSJ).

A key test for the back-to-school season may be when the kids come back from camp, and we see the extent of any possible H1N1 virus. All we know is that there was no shortage of Purell being handed out on Visitor's Day in Muskoka yesterday. See When America Sneezes on page 8 of the weekend FT -- this is still not front page news but the threat of a pandemic is gaining speed, according to the WHO. The Center for Disease Control estimates that without a successful vaccine, 40% of Americans will catch the virus within the next two years.

CONFIDENCE SAGS

The final results of the University of Michigan consumer sentiment survey for July came out on Friday, and a late-month pickup could not prevent confidence from slipping back to 66.0 from 70.8 in June. We like to look at the 'buying conditions' segment, and it fell to a three-month low of 111 from 121 in June. Homebuying intentions faltered as well to 147 from 157; auto plans slid to 133 from 139. Income expectations also dropped to 113 from 120; and 50% now see the unemployment rate rising in coming months, up from 48% in June and 46% in July. Interestingly, opinions about government policy declined from 96 to 91, a five-month low for the White House and Congress.

THE NEW FRUGALITY IS FASHIONABLE

We have been writing about the need for the boomers to start putting more of their money into savings and less into discretionary spending for some time. And, BusinessWeek ran with an article that may sound as if it is has been said before (The Incredible Shrinking Boomer Economy on page 27), but there were some fascinating factoids in the piece (from a McKinsey study):

• The rising savings rates in the boomer population will drain $400 billion out of consumer spending for the foreseeable future.
• The boomer's were such an integral part of the spending culture that the group (79 million) accounted for 47% of national spending before the credit and real estate bubble burst, yet was responsible for just 7% of national savings.
• The boomers were responsible for 78% of the spending growth in the economy from 1995 to 2005.
• The peak year for spending in the boomer community was 54; whereas for the generation ahead of them (a thriftier bunch), the peak year was 47.
• The share of boomers aged 54 to 63 who say they are "financially unprepared for retirement" comes to 69%.

We have said before (repeatedly) that one of the more interesting demographic trends this cycle is that the only segment of the population that is gaining employment is the 55+ age cohort. But this has created a gaping hole in job opportunities for the younger age categories, where jobless rates are either at or approaching the 20% threshold. What is also fascinating is the denial over this demographic reality because many college graduates are holding out for what they believe are going to be lucrative offers -- see In Recession, Optimistic College Graduates Turn Down Jobs on page A10 of the Sunday NYT:
"Job recruiters may be bypassing university campuses in droves and the unemployment rate may be at its highest point in decades, but college career advisers are noticing that many recent graduates do not seem to comprehend the challenging economic world they have just entered". Indeed, as one example of where labour demand is heading, the article cites as an example a recent job fair at the University of Oregon, where just 55 corporate recruiters showed up compared to 90 a year ago.

WHAT'S HAPPENING WITH REVENUES?

According to S&P, only 61% of the companies have beaten their low-balled profit estimates. Yet as we saw in the first quarter, this is being accomplished via aggressive cost-cutting efforts. With 53% of the S&P 500 universe reporting, revenues are down about 10% YoY and the worst is yet to come because the retailers and homebuilders have yet to report. Even so, on an apples-to-apples comparison, sales were -16% YoY in 1Q and -14% in 4Q of last year, so the bulls (who have thus far been correct) would say that this is a classic 'green shoot' second-derivative improvement in the data. The revenue declines have cut a wide swath, with 9 of the 10 sectors and 3 in 4 companies posting contractions.

For those believing the recession is over, let's just say that in the context of an economy that is not in recession, the odds of seeing a negative quarter for revenues is 1-in-13. And, just how bad is a -10% quarter for sales revenues? Well, it would tie the fourth worst performance of the past decade. To put it into perspective, when the 2001 recession ended, sales were running at -1.0% YoY -- what we have now is worse by a factor of ten. And, when the last bull market was confirmed in the spring of 2003, sales had already swung well into positive territory on a YoY basis.

BIG WEEK AHEAD FOR THE BOND MARKET

The U.S. government is going to flood the market with newly minted Treasuries this week -- $200 billion, which will make this the busiest week in 24 years. As of this month, the gross supply of Treasury security issuance has come to $1.25 trillion, up from $434 billion last year and $350 billion at this juncture of 2007. With the yield on the 10-year note still south of 4.0% this attests to the offset from intense deflationary pressures, though the deteriorating fiscal performance and outlook has generated a super-steep yield curve and for the time being established a higher floor for longer-dated yields.

This week, we will see records in the new issuance of 2s, 5s, 7s -- a total of $109 billion, which compares to $104 billion at the June auction and $102bln in May. See page C1 of the WSJ for more.

UPDATE ON THE EMPLOYMENT SCENE

This got very little play, but the minimum wage was lifted on Friday to $7.25 an hour from $6.55 -- a 10.6% increase. That may be great news for the 5 million workers that are affected, but it will likely trigger reduced job creation too as sectors like restaurants and hotels move to contain their aggregate labour bill.

We have said before that the unemployment rate is very likely to continue to rise for the next few years, not just quarters, and that it will take out the November-December 1982 post-WWII peak of 10.8%.

Why is that?

First, it should be noted that in the last cycle, the recession ended in November 2001 and yet the unemployment rate did not reach its peak until June 2003. Considering that the asset deflation and credit collapse this time around was so acute, why would anyone think that it will take less time to reach the peak in the current cycle?

Second, this cycle was most unusual in that 9 million full-time jobs were lost and of these, 3 million were pushed into part-time work. There are now a record 9 million people working part-time that would rather work full-time, which is about 5 million above the norm. On top of that, companies cut the hours worked by a record 2.3% to an all-time low of 33.0 hours this cycle, which is equivalent to another 3 million jobs being lost. So in sum, we have a total level of unemployment and underemployment that comes to 8 million and that is without precedent. So when it comes time to add to labour input again, what businesses are going to do is to raise the workweek and push the part-timers back to full-time work before embarking on a hiring spree. In the meantime, the usual 100,000-150,000 new entrants into the labour force every month will be looking for work with futility. Keep in mind that when we are talking about a total pool of existing labour totaling 8 million jobs, that is equivalent to over five year's supply during a normal business expansion.

Third, the hallmark of this recession was the permanent nature of the job losses that were incurred. Normally, and this includes that period of Ross Perot's "sucking sound" of post-NAFTA being siphoned to Mexico, we lose 2 million permanent jobs in a recession. This is classic Schumpeterian 'creative destruction' as the recession expunges the old uncompetitive industries and paves the way for new more productive sectors -- a recession is a painful but necessary transition to the net cycle as the torch is passed to new technologies.

But this time around we are really talking about the law of large numbers because the total increase in the number of people who lost their jobs permanently exceeded 5 million or twice what is 'normal'. What happens to these people remains to be seen but thus far we see nothing in any 'fiscal package; except for traditional goodies to induce consumption growth. The best fiscal policy of all, and the one that is still not being pursued since it doesn't offer a 'quick fix', is retooling these unemployed individuals, many of them in their 20s and 30s, and providing them with new skills that will bolster long-term productivity growth. It is productivity that is the key variable in the nation's standard-of-living performance, and yet, this has somehow escaped the best and brightest economic minds in Washington -- at least so far. If we can manage to improve education, and thereby income-per-capita, then a whole host of other problems get worked out too -- such a affordable health care (and for a signpost of the problem Obama's plan is running into within his own party, see Blue-Dog Democrats Hold Health-Care Overhaul at Bay on the front page of today's WSJ (without the blue dogs, there are not enough votes on the floor to get the Obama health care plan through).

Another way of looking at the situation is that we are going to end up having some convergence between the popular definition of the unemployment rate and the more inclusive U6 measure -- the former is 9.5% and the latter is 16.5% and this seven percentage point gap is without precedent. At the peak unemployment rate of the last cycle in mid-2003, the gap was four percentage points. As the unutilized labour pool starts to get absorbed again, the U6 is likely to come down and the U1 likely to go up, and if they converge at a four percentage point gap again, then look out -- we'll be talking about an unemployment rate well north of 12% before the jobless recovery comes to an end.

NOT GIVING CREDIT, EVEN WHEN IT'S DUE

The front page of today's WSJ also runs with Loans Shrink as Fear Lingers. The largest 15 U.S. banks cut their loan book by 2.8% in Q2 -- and more than half of the loan volumes came from mortgage refinancings and credit renewals among small businesses (to show how broadly based the credit shrinkage is, 13 of these banks shrank their balance sheet in the second quarter). New credit creation is practically nonexistent. Capital conservation remains the order of the day. This is one critical reason why it would likely be foolhardy to be expecting a normal inventory cycle to come our way merely because of an arithmetic addition to growth from lower de-stocking in the current quarter.

ANOTHER REASON TO BE BULLISH ON EMERGING ASIA

Government efforts are being stepped up to bolster the social safety net and help bring sky-high savings rates down as the U.S. consumer takes its savings rate up. This is good news for commodities since there is a much higher representation of 'material' in the emerging market household consumption basket than is the case for the U.S. household who has become, at the margin, the buyer of services (recreation, medical, financial). See Asian Nations Revisit Safety Net in Effort to Bolster Spending on page A2 of the WSJ.

In our view, it is imperative that Asia finds a new source of growth beyond recurring public sector spending to offset the secular decline in export growth that will be associated with a retrenchment in demand growth in the developed world, primarily in the U.S.A. China currently is only the end-buyer of 22% of the rest of Asia's exports -- it alone is not large enough to provide a complete offset. It likely pays to have a look at the editorial comment.