Outlook us-2011

Stock Market
Outlook
Independent Research & Market Analysis
Published Quarterly by the Investment Policy Committee

2011: Part 1

2011 STOCK MARKET OUTLOOK, PART I

Executive Summary

Stocks ended 2010 on a high note—the MSCI World Index returned +9.0% for the quarter and
+11.8% for the year.i We expect a more subdued 2011 with more modest returns and a much
wider dispersion of returns by category and stock around the averages. Historically, third years
of bull markets are often modestly positive or mildly negative, occasionally very strong, but not
terrible. (See Appendix 2.) And in those years, dispersion increases, and by year end, market
leadership changes. We believe 2011 will be typical of that, reminiscent of 1960, 1977, 1994,
and 2005—pauses that refresh before the next big up-leg. We call it the Year of the Alpha Bet.

In a given year, the stock market can do one of four things: It can be up a lot, up a little, down a
little, or down a lot. We believe only the last, down-a-lot scenario warrants taking defensive
action and exiting stocks. Even if we expect the market to be down a little, the risk of being
wrong and missing a big up year isn’t worth trying to sidestep a small drop.

Fisher Investments 2011 Stock Market Forecast (MSCI World and S&P 500)
Up a Little Most Likely
Down a Little Second Most Likely
Up a Lot Third Most Likely
Down a Lot Least Likely

In each of the last four years, correctly assessing overall stock market direction overwhelmingly
determined investment success or disappointment—much more than the type of stock bought.
Because return dispersion among categories was relatively modest and their directionality near
uniform (big positives in 2007, 2009, and 2010; huge negative in 2008), betting on broad market
and economic trends (what finance calls systemic or “Beta Bets”) was paramount.

By stark contrast, beating 2011’s market should require correct “Alpha Bets” (e.g., picking the
right countries, sectors, industries, individual securities, etc.). In an alpha-driven market, macro
bulls and bears are frustrated because beta is scarce, but making accurate micro decisions can
generate quite satisfactory returns. (See Appendix 3.)

Two years ago, we said the initial, sentiment-driven bounce off the bear market bottom would
eventually subside and fundamental drivers would regain primacy. That transition has begun and
should mature this year.

The widely feared double-dip recession didn’t materialize in 2010. The five little PIIGyS went to
market and came home. Disaster didn’t destroy the recovery. Optimism increased. There are too
many optimists now. There are also too many pessimists, but little in between—a bar-belled,
bifurcated sentiment display, which is rare but not unprecedented. Global economic and
corporate earnings growth should continue, although at increasingly inconsistent rates among
categories. Monetary policy remains highly accommodative, fiscal policy risks have mostly
Past performance is no guarantee of future results. 1
A risk of loss is involved with investing in stock markets. Phone: 800-568-5082
Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.com
Confidential. For personal use only. Website: www.fisherinvestments.com
January 2011

abated, equity valuations remain at big discounts to fixed income, third years of US presidential
cycles have been almost always positive for stocks (if sometimes only slightly), and most major,
identifiable risks seem unlikely to become crises in 2011.

These bullish factors argue against a down-a-lot scenario. The period we earlier described as the
“Pessimism of Disbelief,” however, has ended. Investor sentiment has improved too much, too
fast to make up a lot likely. Dug-in-heels doomers and newly converted acrophobics balance the
virtual sentiment barbell, suggesting the market delivers a widely frustrating middle ground
painful for beta bettors, with a fair degree of volatility along the way.

Done right, 2011 can be a perfectly fine year.

The Investment Policy Committee
Aaron Anderson, Ken Fisher, Bill Glaser, Jeff Silk, and Andrew Teufel

2 Past performance is no guarantee of future results.
Phone: 800-568-5082 A risk of loss is involved with investing in stock markets.
Email: info@fi.com Copyright © 2011 Fisher Investments. All rights reserved.
Website: www.fisherinvestments.com Confidential. For personal use only.
January 2011

Table of Contents

Appendix 1: 2010—A Positive Year With Volatility 4
A Typical Year Two—With PIIGS 4
No Double Dips 5
Appendix 2: 2011 Outlook 6
The Up-a-Little Rationale 6
Barbell Sentiment 8
Positive Fundamental Drivers 9
Balancing the Positives 10
A Correction—and Volatile Periods—Are Possible 11
Why Maintain Maximal Equity Exposure? 11
Appendix 3: The Year of the “Alpha Bet” 12
Fundamentals Regain Primacy 12
A Transition From Low to High Dispersion 14
Appendix 4: Municipal Finance: A Coming Crisis or a Manageable
Challenge? 16
Budget Gaps Are Already Closing 16
Muni Defaults—The Worst Case Scenario 18
Little Contagion Risk 19

January 2011

Appendix 1: 2010—A Positive Year With Volatility
As we have highlighted in the past, stock market momentum from a strong third quarter typically
carries over into the fourth quarter, and 2010 was no exception. After rising nearly 14% in Q3
2010, the MSCI World Index gained 9% in Q4, bringing full-year 2010 returns to +11.8%ii—
within our forecasted range of +10% to +30%.

Exhibit 1: MSCI World Index Performance 2010
1,300

1,250

1,200
Price Index

1,150

1,100

1,050

1,000
Oct-10
Jan-10

Mar-10

Jun-10

Jul-10
May-10

Sep-10
Dec-09

Aug-10

Nov-10

Dec-10
Apr-10
Feb-10

Source: Thomson Reuters, MSCI World Index, 12/31/2009–12/31/2010.

A Typical Year Two—With PIIGS

In many ways, 2010 was a typical bull market second year—above average but not as positive as
year one, featuring skeptical sentiment and continuously improving fundamentals. 2010 was also
decidedly volatile, featuring a sizable pullback early and then a full-blown correction midyear.
Volatility was initially driven by fears Portugal, Ireland, Italy, Greece, and/or Spain (the so-
called PIIGS) could default, resulting in contagion, a fresh financial crisis, and even dissolution
of the European Economic and Monetary Union (EMU) and the end of the euro. Those fears
later morphed into fears of slow European and US growth—the much dreaded “double dip.”
Our view throughout was that fears about PIIGS debt and a double-dip recession exceeded
economic reality. And once that became evident, alleviation of those fears could provide bullish
upside surprise contributing to a back-end loaded year. Indeed, that was largely what happened.

That’s not to say PIIGS debt concerns are completely without merit. (Though they mostly are.
PIIGS finances don’t prevent them from accessing capital markets. They were always rationally
January 2011

able to finance their own debt—some simply got other European countries and the International
Monetary Fund [IMF] to subsidize them.) We have written in the past that a sudden and
disorderly end to the eurozone could be a major negative for markets. But in our view, the larger
EMU countries had strong incentives in the near term to maintain the union, which they
demonstrated through a $1 trillion bailout orchestrated jointly by the European Union, the IMF,
and the European Central Bank (ECB). The bailout effectively covers debt funding needs for all
the PIIGS minus Italy (the fiscally soundest of the little PIIGS) through 2013. Thus far, only
Greece and Ireland have tapped bailout funds while the others continue successfully accessing
credit markets (though at rates undoubtedly higher than they’d like). Portugal may be next in line
for bailout funds, but this is precisely what the bailout mechanism is for.

No Double Dips

In our view, double-dip fears were still more overblown. While many pundits commented that
we were entering a new era of below-average growth and market returns, we were reminded of
Sir John Templeton’s famous “four most dangerous words”—it’s different this time. In our view,
it’s normal in the initial couple years following a recession’s end for skeptics to doubt the
recovery—all while growth exceeds expectations. As 2010’s second half wore on and a double-
dip failed to materialize, sentiment improved, and stocks responded in kind.

Other fears persisted throughout 2010—high unemployment, monetary policy error,
simultaneous and contradictory inflation and deflation fears, slowing Chinese growth, ever-
changing global financial regulation, healthcare regulation, the Macondo oil spill, US debt,
geopolitical saber rattling, a sluggish housing recovery, slow consumer spending, and firms
hoarding cash. Ultimately, the fears were either oversubscribed or not powerful enough to
override myriad global positives.

In all, 2010 was a rewarding though trying year for equity investors—a good reminder that
though stocks over long periods historically deliver superior returns to other similarly liquid
asset classes, it’s never a straight, predictable path to higher asset values—those with patience to
withstand near-term volatility tend to be rewarded in the longer term.

January 2011

Appendix 2: 2011 Outlook
After two years of above-average global stock market returns, we believe 2011 will continue the
bull market but with more flattish results—up a bit or maybe even down a bit. This would be
typical of a bull market’s third year—which is set to begin in March. Further, we expect
increasing dispersion of returns through the year with a potential change in leadership categories
(see Appendix 3). We believe 2011 will be in many ways reminiscent of 1960, 1977, 1994, and
2005—a pause that refreshes before the next major up-leg, and not unusual in the course of a full
bull market.

As always, our tactical asset allocation is guided by our “Four Market Conditions” framework. In
any given year, stocks can do one of four things: They can be up a lot, up a little, down a little, or
down a lot.

Exhibit 2: The Four Market Conditions

Up a Little Up a Lot
(0% to +20%) (+20% or more)

Down a Little Down a Lot
(0% to -20%) (-20% or more)

In our view, up a little is the most likely outcome in 2011. Down a little is second most likely,
and up a lot is third. The least likely scenario in our view is down a lot.

The Up-a-Little Rationale

Historically, bull markets’ third years have never been terrible and only rarely very strong—they
are often a pause in an overall longer bull market. Exhibit 3 shows S&P 500 returns for the first,
second, and third full years of bull markets.

January 2011

Exhibit 3: Third Year of a Bull Market

Bull Market Initial 12 Second 12 Third 12 Total Bull
Start Date Months Months Months Market Return
6/1/1932 120.9% -3.8% 1.5% 323.7%
4/28/1942 53.7% 3.4% 24.6% 157.7%
6/13/1949 42.0% 11.9% 13.1% 267.1%
10/22/1957 31.0% 9.7% -4.8% 86.4%
6/26/1962 32.7% 17.4% 2.0% 79.8%
10/7/1966 32.9% 6.6% -10.2% 48.0%
5/26/1970 43.7% 11.1% -2.5% 73.5%
10/3/1974 38.0% 21.2% -7.1% 125.6%
8/12/1982 58.3% 2.0% 13.4% 228.8%
12/4/1987 21.4% 29.3% -7.1% 64.8%
10/11/1990 29.1% 5.6% 14.5% 417.0%
10/9/2002 33.7% 8.0% 6.6% 101.5%
3/9/2009 68.6% ? ? ?
Average 44.8% 10.2% 3.7% 164.5%

Source: Global Financial Data, Inc., S&P 500 price level returns.

This is not to be confused with the third year of a president’s term—which also coincides with
2011. We have often written that third years of presidents’ terms are overwhelmingly positive
and frequently above average (see Exhibit 4), thanks to increasing gridlock and diminishing
legislative risk aversion. Stocks haven’t been negative in the third year of a president’s term
since 1939, and not significantly negative since 1931. We believe these factors help make a
down-a-lot scenario much less likely in 2011. However, the presidential term phenomenon has
been more widely discussed in media in recent months, which diminishes its power, in our view.

January 2011

Exhibit 4: Presidential Term Anomaly

Party President First Year Second Year Third Year Fourth Year
R Coolidge 1925 N/A 1926 11.1% 1927 37.1% 1928 43.3%
R Hoover 1929 -8.9% 1930 -25.3% 1931 -43.9% 1932 -8.9%
D FDR - 1st 1933 52.9% 1934 -2.3% 1935 47.2% 1936 32.8%
D FDR - 2nd 1937 -35.3% 1938 33.2% 1939 -0.9% 1940 -10.1%
D FDR - 3rd 1941 -11.8% 1942 21.1% 1943 25.8% 1944 19.7%
D FDR / Truman 1945 36.5% 1946 -8.2% 1947 5.2% 1948 5.1%
D Truman 1949 18.1% 1950 30.6% 1951 24.6% 1952 18.5%
R Ike - 1st 1953 -1.1% 1954 52.4% 1955 31.4% 1956 6.6%
R Ike - 2nd 1957 -10.9% 1958 43.3% 1959 11.9% 1960 0.5%
D Kennedy / Johnson 1961 26.8% 1962 -8.8% 1963 22.7% 1964 16.4%
D Johnson 1965 12.4% 1966 -10.1% 1967 23.9% 1968 11.0%
R Nixon 1969 -8.5% 1970 3.9% 1971 14.3% 1972 19.0%
R Nixon / Ford 1973 -14.7% 1974 -26.5% 1975 37.2% 1976 23.9%
D Carter 1977 -7.2% 1978 6.6% 1979 18.6% 1980 32.5%
R Reagan - 1st 1981 -4.9% 1982 21.5% 1983 22.6% 1984 6.3%
R Reagan - 2nd 1985 31.7% 1986 18.7% 1987 5.3% 1988 16.6%
R Bush 1989 31.7% 1990 -3.1% 1991 30.5% 1992 7.6%
D Clinton - 1st 1993 10.1% 1994 1.3% 1995 37.6% 1996 23.0%
D Clinton - 2nd 1997 33.4% 1998 28.6% 1999 21.0% 2000 -9.1%
R Bush, GW - 1st 2001 -11.9% 2002 -22.1% 2003 28.7% 2004 10.9%
R Bush, GW - 2nd 2005 4.9% 2006 15.8% 2007 5.5% 2008 -37.0%
D Obama 2009 26.5% 2010 15.1% 2011 --- 2012 ---
Average 8.1% 8.9% 19.3% 10.9%

Source: Thomson Reuters, S&P 500 total return.

Barbell Sentiment

Another powerful factor influencing our forecast is bifurcated sentiment. The past few years
have been dominated by sentiment so dour we called it the “pessimism of disbelief”—the notion
most everything economic is either negative or will eventually become negative. In his February
2010 Forbes column, our CEO, Ken Fisher, wrote: “The public’s mood is to notice anything bad
(like 10% unemployment) while dismissing anything good (like narrowing credit spreads) as not
credible.” However, with the strong stock rally following 2010’s midsummer correction,
sentiment has improved—for some.

The strength of the global economic recovery and stock market resilience in the face of myriad
fears have converted many formerly cautious forecasters to outright bulls who seem to simply
extrapolate recent trends out indefinitely. As discussed later in this appendix, fundamentals
should continue to strengthen this year. But what drives stocks is the disconnect between

January 2011

expectations and reality. As 2010 began, investor sentiment was exceptionally dour, so even
modest economic improvement easily surpassed expectations. Since then, the bar has been
moved higher. Fundamentals should again exceed expectations, but by a less spectacular margin,
providing less oomph for stocks and reducing the likelihood of an up-a-lot year (though we still
see an up-a-lot year as a more likely outcome than a down-a-lot year—just not most likely).

However, better fundamentals haven’t swayed steadfast doom-and-gloomers, who are mostly
sticking to their bearish guns despite the many signs of economic and stock market
improvement. The “permabear” contingent is still larger and regarded more credibly than
before the bear market, and they’ve recently been joined by newbie acrophobes scared bearish
by the market’s recent rise. The influence of these bears similarly reduces the chances for a
down-a-lot year.

Sentiment today is akin to a barbell—with some persistently, strongly, “dug-in heels” bearish,
others quite positive, and dearth in the middle. These strongly opposed forces likely cancel one
another, creating more sideways trends for stocks generally. Ken often refers to the stock market
as The Great Humiliator—its sole intent is to humiliate as many people as possible for as long as
possible for as much money as possible. A good way to humiliate the most people when
sentiment is so divided is to deliver muted returns—to the agony of bulls and bears alike—
hurting the foolishly greedy and the foolishly fearful.

Positive Fundamental Drivers

Though our forecast is for stocks to be up a little, fundamentals remain strong, further
diminishing the odds of a down-a-lot scenario. Among them:

x An ongoing economic expansion will likely meet or exceed expectations globally
x Corporate profits on average should continue beating expectations
x Stock valuations remain attractive relative to bonds
x Monetary policy remains highly accommodative almost everywhere
x US tax cut extensions diminished fiscal policy risks
x Political gridlock is increasing globally
x Most major, identifiable risks appear unlikely to be 2011 events

The global economic expansion led by Emerging Markets continues apace. The US and much of
Europe have reaccelerated from slower growth rates this past summer across a variety of metrics.
Growth outlooks for 2011 are much sunnier than they were for 2010, when a “double dip” was
widely heralded (yet never appeared). But expectations, though improved, are likely still overly
cautious—though not as cautious as in 2010. Looking forward, we believe Emerging Markets
will best developed markets economically, and the US economy is well positioned to outperform
most other developed countries.

Corporate earnings growth should again beat expectations, driven by increasing top-line sales,
greater efficiency and productivity, and the deployment of a still near-historic mountain of
cash on firms’ balance sheets, although growth rates will be less than in 2010 thanks to more
January 2011

difficult year-over-year comparisons starting from a not-so-depressed base. Also, rapidly
increasing earnings in 2010 helped keep stock valuations attractive relative to fixed income. In
fact, earnings growth far outpaced stock price growth, causing earnings multiples to decline in
2010 despite healthy stock returns. S&P 500 earnings growth was above 30% for a historically
rare three consecutive quarters—58.3% in Q1, 38.8% in Q2, and 31.2% in Q3—and
expectations are for 32% in Q4.iii Earnings globally were similarly strong. As of December 31,
2010, the MSCI World Index’s earnings yield is 8.02%—a wide 4.7% above current GDP-
weighted world bond yields.iv

Globally, central banks have largely kept their accommodative stance to varying degrees. In
the US, the Fed introduced a second round of quantitative easing (QE2), expanding its balance
sheet by purchasing medium-maturity US Treasuries. Though we believe the Fed’s initial
quantitative easing (QE1) was appropriate given the credit market lockup during the 2008
financial panic, we view QE2 as unnecessary and largely redundant—maybe even silly. A lack
of base money liquidity isn’t inhibiting the US or global economy. On the contrary, economies
are awash in liquidity. If anything, a lack of confidence is preventing liquidity from flowing
through the economy as it normally would, and QE2 could undermine, not enhance, that
confidence. Additionally, QE2 likely complicates the Fed’s exit from exceptional
accommodation—though this likely isn’t a 2011 issue. However, as QE2 is implemented
through midyear, the excess liquidity supplied likely flows into capital markets, providing a
near-term tailwind for stocks. In Europe, the ECB has actually done the reverse—modestly
shrinking its balance sheet but buying PIIGS debt to keep the bond market liquid. In select
Emerging Markets, strong economic growth and bubbling inflation concerns have caused
central bankers to begin raising interest rates. But overall, monetary policy globally remains
highly accommodative—a near-term positive for stocks.

In recent months, US fiscal policy risks have abated. The recent US tax rate extension removes a
source of uncertainty and a potential incremental economic negative (see Appendix 4). Corporate
tax rates have fallen globally in recent years. The US has lagged the rest of the world in cutting
corporate tax rates so far, but falling tax rates abroad put pressure on the US to follow suit. Thus,
constructive US corporate tax reform remains a possibility. As mentioned earlier, we believe the
fundamentally positive force of the third year of a presidential term may be muted somewhat in
2011 because it’s more widely recognized than in years past. However, gridlock is increasing
globally, which should still help diminish political risk aversion.

Lastly, most major, identifiable risks (e.g., final resolution to the eurozone sovereign debt
problems) are unlikely to be 2011 crises. Put simply, those biased to bearishness have been
unable to come up with new, materially different risks despite having looked endlessly. The wide
discussion of common concerns has discounted them into stocks quite effectively—reducing the
likelihood, they have a major negative impact on prices.

Balancing the Positives

Fundamentals are strong and outweigh potential negatives, in our view. Still, the existence of
increasingly optimistic sentiment counterbalances those positives and diminishes the odds of
January 2011

an up-a-lot year. An example: The US investor political class, dominated by Republicans over
Democrats by an approximately 2-to-1 ratio, may take too much comfort in November’s
midterm victories. Regardless of what happens in 2012, this group is likely to find
disappointment in 2011 as it becomes apparent that what elected politicians do is usually vastly
different from what campaigning politicians say. Many measures House Republicans
campaigned on could be inhibited by gridlock since they must overcome a Senate opposition
majority and a presidential veto. We’ve said often gridlock is good for stocks, but
Republicans’ disappointment their 2010 landslide victory doesn’t immediately result in pro-
business change could temporarily weigh on stocks.

A Correction—and Volatile Periods—Are Possible

An “up-a-little” year doesn’t necessarily mean uneventful or bad. Could be very nice. As we saw
in 2010, market corrections occur frequently, are normal, and should be expected in the normal
course of a bull market. It wouldn’t be surprising if one happens again this year. And even if a
full-blown correction doesn’t occur, pullbacks and periods of heightened volatility are simply
normal in any bull market year. The barbell-based sentiment we see today doesn’t preclude
volatility—perhaps the best description is a back-and-forth tug-of-war. Expect volatility.

Why Maintain Maximal Equity Exposure?

If our outlook is for stocks to be up a little, why not sidestep the relative difficulty of near-term
volatility and wait until up a lot seems more likely by going to cash now? First and foremost, an
up-a-little year for stocks broadly can be a perfectly good year for portfolios. As explained in
Appendix 3, country, sector, industry, and security selection decisions simply become more
important than calling market direction.

One of the rules we employ in managing portfolios is always knowing we could be wrong.
Portfolio management is inherently a business of probabilities, not certainties. The market is far
more likely to be either up a lot, up a little, or down a little than it is to be down a lot in any
given year. None of these first three scenarios warrants a defensive posture in our view. The first
two are positive, and up a lot happens much more frequently than down a lot. If we forecast up a
little or down a little this year, there’s a chance our outlook could be too tepid. If we reduced
equity exposure, the opportunity cost relative to the benchmark could be very large in an up-a-lot
scenario. Capturing big market up moves is essential to achieving long-term stock market
growth. Trying to sidestep small moves can easily undermine that goal.

Another important consideration is the relative attractiveness of equities versus fixed income and
cash alternatives. Entering 2011, we feel these alternatives are less attractive compared to stocks
and not worth the potential opportunity cost. Interest rates on cash or cash-like instruments
remain next to nothing. Fixed income alternatives are, in many cases, similarly low yielding and
interest rates across the board remain historically low. While we don’t believe interest rates will
rise dramatically in 2011, even a small rise would depress prices. A modest year for stocks
should be superior to most alternatives this year.

January 2011

Appendix 3: The Year of the “Alpha Bet”
The last several years have been highlighted by sizable global stock market moves—up nicely in
2007, down massively in 2008, up big in 2009, and up nicely again in 2010. Getting the direction
of those moves right and betting on stock categories with appropriate betas largely determined
short-term investing success. (“Beta” is a measure of how a stock or category moves relative to
the broader market.) All else equal, high beta categories tend to outperform in up markets and
low beta categories tend to outperform in down markets. Overweighting high beta categories like
Emerging Markets, Materials, and Energy stocks was a successful strategy for much of 2007,
2009, and 2010. Similarly, low beta categories like Health Care, Utilities, and Consumer Staples
outperformed in 2008. We believe 2011 will be a different type of year, with more muted overall
returns and “beta bets” playing much less prominent roles. Instead, making correct “alpha
bets”—determining how categories (e.g., country, sector, industry, and style) and securities will
perform versus the broad market due to specific fundamental factors as opposed to broad macro
factors—will be more important this year.

Fundamentals Regain Primacy

In a new bull market, we believe returns are initially driven by a reversal of sentiment and influx of
liquidity. We believe these have been the dominant forces driving returns for the past two years.
In 2009, the bounce theme worked well, as the categories that performed worst at the tail end of
the bear market bounced the most (see Exhibit 5). That trend largely continued in 2010 (see
Exhibit 6)—Financials, was a notable exception—but with less force and consistency than 2009.

January 2011

Exhibit 5: Sector Bounce Theme 2009
140%
125%
120% 9/9/08 - 3/9/09
100% 96% 3/9/09 - 12/31/09
77% 75% 79%
80%

60% 49% 48% 45%
36% 40%
40%

20%

0%

-20%

-40% -35% -34% -33% -32%
-36%
-45% -41%
-60% -50% -48%

-66%
-80%

Utilities
Materials

Health Care
Energy
Industrials

Discretionary

Telecomm.
Technology
Financials

Consumer Staples
Consumer

Source: Thomson Reuters. MSCI World Price Level Returns (USD).

Exhibit 6: Sector Bounce Theme 2010
140%
120%
9/9/08 - 3/9/09
100% 12/31/09 - 12/31/10
80%
60%
40%
21% 19% 23%
20% 10% 10% 10%
2% 5% 0%
0%
-5%
-20%
-40% -34% -33% -32%
-36% -35%
-45% -41%
-60% -50% -48%

-80% -66%
Utilities

Health Care
Industrials

Energy
Discretionary

Telecomm.
Technology
Financials

Materials

Consumer Staples
Consumer

Source: Thomson Reuters. MSCI World Price Level Returns (USD).

January 2011

We expect sentiment and liquidity forces to continue to give way to renewed investor focus on
fundamentals in 2011. This process, however, won’t happen overnight—it’s more likely to be a
gradual transition. At present, we believe fundamentals favor certain Emerging Markets
countries and US stocks over those in Europe and Japan. From a sector standpoint, Industrials,
Technology, Materials, Consumer Discretionary, and Energy are likely to lead, at least initially.

A Transition From Low to High Dispersion

Another stock market feature favoring “beta bets” over “alpha bets” in recent years has been
relatively high correlations among stock categories and among individual securities within
categories. The recession, financial panic, and subsequent recovery were truly global
phenomena. This year, localized forces are likely to be more prominent than huge macro events.
Return dispersion should increase as a result and is likely to comprise a much larger proportion
of overall portfolio returns in 2011 than in recent years. In a year like this, “alpha bets” will
dominate, and successful pickers of categories and stocks will likely win.

The more granular internal components (industry and stock) have already shown increasing
dispersion (see Exhibits 7 and 8), which we expect to grow and probably also lead to a drop in
country and sector level correlations. Once the trend toward higher dispersion begins, it tends to
persist for several years. As Exhibits 7 and 8 show, the mid-1990s, late 1990s and early 2000s,
and mid-2000s were marked by several consecutive years of below average correlations.

Exhibit 7: Intra-Stock Correlation Decreasing

100%
Correlation
90% Long Term Avg
Average correlation for constituent pairs

80% Intra-stock correlations were very high - the market was trading on
hysteria rather than fundamentals
70%

60%

50%

40%

30%

20%

10%

0%
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Source: Thomson Reuters, 500 largest US stocks daily returns per quarter.

January 2011

Exhibit 8: Intra-Industry Correlation Decreasing
100%

90% Correlation
Long Term Avg
80%

70%

60%

50%

40%

30%

20%

10%

0%
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010
Source: Thomson Reuters, S&P 500 weekly industry returns per quarter.

Because of the forces described above, developing successful high-level investment themes was
largely sufficient in recent years. Correctly forecasting whether global economic growth would
be above or below expectations and emphasizing more or less economically sensitive categories
went a long way toward beating the market. Similarly, overweighting Emerging Markets in
aggregate has been about as effective as selecting individual Emerging Markets countries. With
little dispersion among and within categories, more narrowly focused themes were less
impactful. In our view, beating the market in 2011 will require more focused portfolio themes
and successful stock picking.

January 2011

Appendix 4: Municipal Finance: A Coming Crisis or a Manageable
Challenge?
In light of recent weakness in the municipal bond market, many fear state and local governments
must choose one of two unattractive options—either making draconian fiscal adjustments or
defaulting on potentially hundreds of billions of dollars of debt. In many ways, muni fears are a
variant of 2010’s PIIGS debt fears, but on a smaller scale and with a less ominous transmission
mechanism. Many people particularly concerned about municipal finances are the same who
fretted the PIIGS in 2010—munis are just a new justification for their bearishness. And like
PIIGS fears, muni debt concerns are likely overblown in the near term, and the threat isn’t
sufficient to derail the US or global economic expansion in 2011 in our opinion.

The effects of recession and recovery don’t hit all at once. Investors feel it first as the stock
market discounts future economic conditions. Main Street’s jolt is coincident or slightly lagging
as employment—a lagging indicator—recovers more slowly. Governments inherently feel a
recession’s brunt and the subsequent recovery with a significant lag because tax receipts—their
primary revenue source—are mostly collected after income is received. In every recession, tax
revenues across the board fall, and with every recovery, they rebound—this is normal. Most state
and local governments are likely to see funding gaps narrow over the next few years as tax
revenues rebound with the economy. And while some municipal bond issuers may face default in
the absence of a state and/or federal bailout, broader contagion is unlikely.

Budget Gaps Are Already Closing

The recent recession did indeed pressure state and local government finances. From Q2 2008 to
the Q2 2009, state and local tax revenue fell 9% as individual incomes and corporate earnings
fell. Yet total spending remained flat—a reduction in discretionary spending was offset by
accelerating social benefits payments.v As a result, aggregate state budget gaps surged from $13
billion in fiscal year 2008 to $117 billion in 2009 and $174 billion in 2010.vi Although the
federal government provided $192.9 billion in fiscal stimulus to states and local municipalities,vii
many states had to cut budgets, draw down rainy day funds, or resort to accounting gimmickry to
balance their budgets.

However, the situation has improved materially with the economic recovery. Tax receipts have
rebounded 8.4% from their low and are now only 1.4% below pre-recession highsviii (see Exhibit
9). And while social benefits payments continue to advance at a high single-digit rate, ongoing
discretionary spending cuts have constrained growth in outlays overall.

January 2011

Exhibit 9: State and Local Government Tax Receipts
15% $1,600
Billions of Dollars
Year-over-Year Change $1,400

10%
$1,200
Year-over-Year Change

$1,000
5%

($Billions)
$800

0%
$600

$400
-5%

$200

-10% $0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Source: US Dept. of Commerce, Bureau of Economic Analysis, National Income and Product
Accounts Table 3.3, State and Local Government Current Receipts and Expenditures (seasonally
adjusted at annual rates).

Rising tax receipts have allowed states to narrow deficits and reduce borrowing activity. The
National Conference of State Legislatures recently estimated state budget gaps are expected to
fall to $111 billion in fiscal year 2011 and $82 billion in 2012.

States also appear adequately positioned now to meet near-term financial obligations. The
aggregate debt-to-tax revenue ratio for state and local governments stands at 1.80 (see Exhibit
10). This is above recent norms but below the levels seen through most of the 1980s and is
already trending down. Moreover, the aggregate tax-receipts-to-interest-payments ratio—a
measure of state and local governments’ ability to make debt service payments—stands at 11.9,
lower than pre-recession highs, but above the 30-year average (the higher, the better).

January 2011

Exhibit 10: Financial Leverage Ratios for States and Local Governments
30 3

While debt levels remain elevated relative to
tax revenue, they are below the levels that
were sustained through much of the 1980s,
and are currently trending down.
Tax Revenue / Interest Payments

Total Debt to / Tax Revenue
20 2

10 1
Tax Receipts / Interest Payments
Total Debt / Tax Revenue Debt service costs are a smaller
percentage of tax revenue than they have
been for most of the last 30 years.

- -
1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

2006
Source: US Dept. of Commerce, Bureau of Economic Analysis, National Income and Product
Accounts Table 3.3, State and Local Government Current Receipts and Expenditures (seasonally-
adjusted at annual rates); Federal Reserve Flow of Funds, Table L.2.

Though state and local government fiscal positions are improving, fiscal situations vary state to
state and city to city. It wouldn’t be surprising if some municipalities are unable to meet their
obligations—local defaults happen from time to time. In those situations, states typically support
municipalities—and the federal government could provide additional support at the state level. In
fact, it would be near unprecedented for the federal government to allow a state to default. (A
state hasn’t defaulted since 1933, not because they haven’t been in financial distress, but because
the federal government has eased the burden.)

Muni Defaults—The Worst Case Scenario

Even if state and/or local governments are allowed to default, the magnitude of losses would
likely be relatively limited. Currently there is about $2.9 trillion in total outstanding municipal
debt—about 25% smaller than the amount of PIIGS debt and about one-fifth the size of the US
mortgage market.ix $2.9 trillion is not a small number, but even if default rates hit the highest
levels recorded during the Great Depression—the worst period of municipal defaults in history—
the outcome likely wouldn’t be as dire as many fear.

Between 1929 and 1937, about 4800 municipal bond issuers defaulted on about 7.3% of average
outstanding debt.x Assuming Great Depression conditions (improbable given ongoing recovery)
a 7.3% default rate would mean about $212 billion in defaults—a sizable amount. However,
January 2011

muni principal and interest payments are typically deferred rather than canceled, so the ultimate
recovery rate is usually very high. Even during the Great Depression the recovery rate on
defaulted debt was about 99.5%.xi Assuming a similar recovery rate today, final losses for
municipal creditors would be only about $1.1 billion—or roughly 0.1% of the IMF’s estimate for
write-downs on US mortgage loans and securities from 2007-2010.xii

Even if applying conditions from the single worst Great Depression year (1933)—when
municipal bond issuers defaulted on 16% of interest and principal payments—losses would
likely still be digestible. Municipal issuers now pay about $400 billion in interest and principal
annually. A 16% default rate would mean $64 billion in losses—before any recovery. Not great,
but not very big relative to America’s $15 trillion economy or the world’s $62 trillion
economyxiii—and certainly not the hundreds of billions in losses many fear.

Little Contagion Risk

In addition to being smaller in magnitude, the municipal bond market has far less financial
contagion risk than subprime or even PIIGS debt. During the credit crisis, the troubles in the
subprime market forced financial institutions to take capital losses on highly leveraged structured
debt instruments, which in turn forced them to sell assets at fire-sale prices to meet regulatory
capital requirements. These forced sales pushed asset prices down further, driving further
deleveraging—a rare, self-perpetuating cycle.

This same cycle is unlikely with municipal bonds. Most of the debt (about 70%) is held by
households and long-only mutual funds (see Exhibit 11), not highly leveraged banks and broker-
dealers (as was the case with subprime mortgages and, to a lesser extent, Europe sovereign debt).
And for those financial institutions that do own municipal debt, the institutions themselves are
far less leveraged today than a few years ago.

Exhibit 11: Municipal Debt Outstanding, by Sector

Sector Billion % of total
Households $1,059 37.1%
Funds $947 33.2%
Insurance Companies $448 15.7%
Banks and Broker Dealers $269 9.4%
Other $134 4.7%
Total $2,857 100.0%

Source: Federal Reserve, Flow of Funds, Table L.211.

Some states will face tough choices longer term in wrangling with ballooning entitlements. But
that is more a political issue—leaders making hard, unpopular decisions—than a true,
irrevocable systemic fiscal crisis. For 2011, muni debt issues are likely to feature prominently in
headlines but are unlikely to be a major economic crisis.

January 2011

This review constitutes the general views of Fisher Investments and should not be regarded as
personalized investment advice. No assurances are made we will continue to hold these views,
which may change at any time based on new information, analysis or reconsideration. In
addition, no assurances are made regarding the accuracy of any forecast made herein. The
MSCI World Index measures the performance of selected stocks in 24 developed countries and
is presented net of dividend withholding taxes and uses a Luxembourg tax basis. The S&P 500
Composite Index is a capitalization-weighted, unmanaged index that measures 500 widely held
US common stocks of leading companies in leading industries, representative of the broad US
equity market. Past performance is no guarantee of future results. A risk of loss is involved
with investments in stock markets.

i
Thomson Reuters
ii
Thomson Reuters
iii
Thomson Reuters
iv
Bloomberg, Thomson One Analytics. Japan’s 10-year rate as of 11/30/2010 was used in calculation of the
weighted world yield curve.
v
US Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts Table 3.3,
State and Local Government Current Receipts and Expenditures (seasonally-adjusted at annual rates)
vi
National Conference of State Legislatures, State Budget Update: November 2010
vii
Government Accountability Office; as of 12/31/2010. www.gao.gov/recovery
viii
US Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts Table 3.3,
State and Local Government Current Receipts and Expenditures (seasonally-adjusted at annual rates)
ix
US Federal Reserve Flow of Funds Table L.2 for US mortgage debt; Bloomberg as of 1/11/11
x
Hemple, George H, “The Postwar Quality of State and Local Debt,” Published by the National Bureau of
Economic Research, 1971
xi
Hemple, George H, “The Postwar Quality of State and Local Debt,” Published by the National Bureau of
Economic Research, 1971
xii
IMF Global Financial Stability Report, Table 1.3 “Estimates of Financial Sector Potential Write-downs (2007-
2010) by Geographic Origin of Assets as of April 2009.” Study puts total losses on US-originated mortgage
loans and securities at $1,062 billion.
xiii
International Monetary Fund. Estimate as of 12/31/2010.

M.01.034-Q1110128

January 2011

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