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  • 1. Stock MarketOutlookIndependent Research & Market AnalysisPublished Quarterly by the Investment Policy Committee2011: Part 1
  • 2. 2011 STOCK MARKET OUTLOOK, PART IExecutive SummaryStocks 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 muchwider dispersion of returns by category and stock around the averages. Historically, third yearsof bull markets are often modestly positive or mildly negative, occasionally very strong, but notterrible. (See Appendix 2.) And in those years, dispersion increases, and by year end, marketleadership 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 alittle, or down a lot. We believe only the last, down-a-lot scenario warrants taking defensiveaction and exiting stocks. Even if we expect the market to be down a little, the risk of beingwrong 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 LikelyIn each of the last four years, correctly assessing overall stock market direction overwhelminglydetermined investment success or disappointment—much more than the type of stock bought.Because return dispersion among categories was relatively modest and their directionality nearuniform (big positives in 2007, 2009, and 2010; huge negative in 2008), betting on broad marketand 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 theright countries, sectors, industries, individual securities, etc.). In an alpha-driven market, macrobulls and bears are frustrated because beta is scarce, but making accurate micro decisions cangenerate quite satisfactory returns. (See Appendix 3.)Two years ago, we said the initial, sentiment-driven bounce off the bear market bottom wouldeventually subside and fundamental drivers would regain primacy. That transition has begun andshould mature this year.The widely feared double-dip recession didn’t materialize in 2010. The five little PIIGyS went tomarket and came home. Disaster didn’t destroy the recovery. Optimism increased. There are toomany 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 andcorporate earnings growth should continue, although at increasingly inconsistent rates amongcategories. Monetary policy remains highly accommodative, fiscal policy risks have mostlyPast performance is no guarantee of future results. 1A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 3. abated, equity valuations remain at big discounts to fixed income, third years of US presidentialcycles 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, toofast to make up a lot likely. Dug-in-heels doomers and newly converted acrophobics balance thevirtual sentiment barbell, suggesting the market delivers a widely frustrating middle groundpainful for beta bettors, with a fair degree of volatility along the way.Done right, 2011 can be a perfectly fine year.The Investment Policy CommitteeAaron Anderson, Ken Fisher, Bill Glaser, Jeff Silk, and Andrew Teufel2 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
  • 4. Table of ContentsAppendix 1: 2010—A Positive Year With Volatility 4 A Typical Year Two—With PIIGS 4 No Double Dips 5Appendix 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? 11Appendix 3: The Year of the “Alpha Bet” 12 Fundamentals Regain Primacy 12 A Transition From Low to High Dispersion 14Appendix 4: Municipal Finance: A Coming Crisis or a ManageableChallenge? 16 Budget Gaps Are Already Closing 16 Muni Defaults—The Worst Case Scenario 18 Little Contagion Risk 19Past performance is no guarantee of future results. 3A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 5. Appendix 1: 2010—A Positive Year With VolatilityAs we have highlighted in the past, stock market momentum from a strong third quarter typicallycarries over into the fourth quarter, and 2010 was no exception. After rising nearly 14% in Q32010, 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-10Source: Thomson Reuters, MSCI World Index, 12/31/2009–12/31/2010.A Typical Year Two—With PIIGSIn many ways, 2010 was a typical bull market second year—above average but not as positive asyear one, featuring skeptical sentiment and continuously improving fundamentals. 2010 was alsodecidedly 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 dissolutionof the European Economic and Monetary Union (EMU) and the end of the euro. Those fearslater 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 exceededeconomic reality. And once that became evident, alleviation of those fears could provide bullishupside 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 rationally4 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
  • 6. able to finance their own debt—some simply got other European countries and the InternationalMonetary Fund [IMF] to subsidize them.) We have written in the past that a sudden anddisorderly end to the eurozone could be a major negative for markets. But in our view, the largerEMU countries had strong incentives in the near term to maintain the union, which theydemonstrated 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 allthe PIIGS minus Italy (the fiscally soundest of the little PIIGS) through 2013. Thus far, onlyGreece and Ireland have tapped bailout funds while the others continue successfully accessingcredit markets (though at rates undoubtedly higher than they’d like). Portugal may be next in linefor bailout funds, but this is precisely what the bailout mechanism is for.No Double DipsIn our view, double-dip fears were still more overblown. While many pundits commented thatwe were entering a new era of below-average growth and market returns, we were reminded ofSir 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 therecovery—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 firmshoarding cash. Ultimately, the fears were either oversubscribed or not powerful enough tooverride myriad global positives.In all, 2010 was a rewarding though trying year for equity investors—a good reminder thatthough stocks over long periods historically deliver superior returns to other similarly liquidasset classes, it’s never a straight, predictable path to higher asset values—those with patience towithstand near-term volatility tend to be rewarded in the longer term.Past performance is no guarantee of future results. 5A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 7. Appendix 2: 2011 OutlookAfter two years of above-average global stock market returns, we believe 2011 will continue thebull market but with more flattish results—up a bit or maybe even down a bit. This would betypical of a bull market’s third year—which is set to begin in March. Further, we expectincreasing 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, and2005—a pause that refreshes before the next major up-leg, and not unusual in the course of a fullbull market.As always, our tactical asset allocation is guided by our “Four Market Conditions” framework. Inany given year, stocks can do one of four things: They can be up a lot, up a little, down a little, ordown 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 RationaleHistorically, bull markets’ third years have never been terrible and only rarely very strong—theyare 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.6 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
  • 8. 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 with2011. We have often written that third years of presidents’ terms are overwhelmingly positiveand frequently above average (see Exhibit 4), thanks to increasing gridlock and diminishinglegislative risk aversion. Stocks haven’t been negative in the third year of a president’s termsince 1939, and not significantly negative since 1931. We believe these factors help make adown-a-lot scenario much less likely in 2011. However, the presidential term phenomenon hasbeen more widely discussed in media in recent months, which diminishes its power, in our view.Past performance is no guarantee of future results. 7A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 9. Exhibit 4: Presidential Term AnomalyParty 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 8 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
  • 10. expectations and reality. As 2010 began, investor sentiment was exceptionally dour, so evenmodest economic improvement easily surpassed expectations. Since then, the bar has beenmoved 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 stillsee 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 mostlysticking to their bearish guns despite the many signs of economic and stock marketimprovement. The “permabear” contingent is still larger and regarded more credibly thanbefore the bear market, and they’ve recently been joined by newbie acrophobes scared bearishby the market’s recent rise. The influence of these bears similarly reduces the chances for adown-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 oneanother, creating more sideways trends for stocks generally. Ken often refers to the stock marketas The Great Humiliator—its sole intent is to humiliate as many people as possible for as long aspossible for as much money as possible. A good way to humiliate the most people whensentiment 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 DriversThough our forecast is for stocks to be up a little, fundamentals remain strong, furtherdiminishing 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 eventsThe global economic expansion led by Emerging Markets continues apace. The US and much ofEurope 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” waswidely heralded (yet never appeared). But expectations, though improved, are likely still overlycautious—though not as cautious as in 2010. Looking forward, we believe Emerging Marketswill best developed markets economically, and the US economy is well positioned to outperformmost 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 ofcash on firms’ balance sheets, although growth rates will be less than in 2010 thanks to morePast performance is no guarantee of future results. 9A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 11. difficult year-over-year comparisons starting from a not-so-depressed base. Also, rapidlyincreasing earnings in 2010 helped keep stock valuations attractive relative to fixed income. Infact, earnings growth far outpaced stock price growth, causing earnings multiples to decline in2010 despite healthy stock returns. S&P 500 earnings growth was above 30% for a historicallyrare three consecutive quarters—58.3% in Q1, 38.8% in Q2, and 31.2% in Q3—andexpectations 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.ivGlobally, central banks have largely kept their accommodative stance to varying degrees. Inthe US, the Fed introduced a second round of quantitative easing (QE2), expanding its balancesheet by purchasing medium-maturity US Treasuries. Though we believe the Fed’s initialquantitative easing (QE1) was appropriate given the credit market lockup during the 2008financial panic, we view QE2 as unnecessary and largely redundant—maybe even silly. A lackof base money liquidity isn’t inhibiting the US or global economy. On the contrary, economiesare awash in liquidity. If anything, a lack of confidence is preventing liquidity from flowingthrough the economy as it normally would, and QE2 could undermine, not enhance, thatconfidence. Additionally, QE2 likely complicates the Fed’s exit from exceptionalaccommodation—though this likely isn’t a 2011 issue. However, as QE2 is implementedthrough midyear, the excess liquidity supplied likely flows into capital markets, providing anear-term tailwind for stocks. In Europe, the ECB has actually done the reverse—modestlyshrinking its balance sheet but buying PIIGS debt to keep the bond market liquid. In selectEmerging Markets, strong economic growth and bubbling inflation concerns have causedcentral bankers to begin raising interest rates. But overall, monetary policy globally remainshighly accommodative—a near-term positive for stocks.In recent months, US fiscal policy risks have abated. The recent US tax rate extension removes asource of uncertainty and a potential incremental economic negative (see Appendix 4). Corporatetax rates have fallen globally in recent years. The US has lagged the rest of the world in cuttingcorporate 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 thefundamentally positive force of the third year of a presidential term may be muted somewhat in2011 because it’s more widely recognized than in years past. However, gridlock is increasingglobally, which should still help diminish political risk aversion.Lastly, most major, identifiable risks (e.g., final resolution to the eurozone sovereign debtproblems) are unlikely to be 2011 crises. Put simply, those biased to bearishness have beenunable to come up with new, materially different risks despite having looked endlessly. The widediscussion of common concerns has discounted them into stocks quite effectively—reducing thelikelihood, they have a major negative impact on prices.Balancing the PositivesFundamentals are strong and outweigh potential negatives, in our view. Still, the existence ofincreasingly optimistic sentiment counterbalances those positives and diminishes the odds of10 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
  • 12. an up-a-lot year. An example: The US investor political class, dominated by Republicans overDemocrats by an approximately 2-to-1 ratio, may take too much comfort in November’smidterm victories. Regardless of what happens in 2012, this group is likely to finddisappointment in 2011 as it becomes apparent that what elected politicians do is usually vastlydifferent from what campaigning politicians say. Many measures House Republicanscampaigned on could be inhibited by gridlock since they must overcome a Senate oppositionmajority and a presidential veto. We’ve said often gridlock is good for stocks, butRepublicans’ disappointment their 2010 landslide victory doesn’t immediately result in pro-business change could temporarily weigh on stocks.A Correction—and Volatile Periods—Are PossibleAn “up-a-little” year doesn’t necessarily mean uneventful or bad. Could be very nice. As we sawin 2010, market corrections occur frequently, are normal, and should be expected in the normalcourse of a bull market. It wouldn’t be surprising if one happens again this year. And even if afull-blown correction doesn’t occur, pullbacks and periods of heightened volatility are simplynormal in any bull market year. The barbell-based sentiment we see today doesn’t precludevolatility—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-termvolatility and wait until up a lot seems more likely by going to cash now? First and foremost, anup-a-little year for stocks broadly can be a perfectly good year for portfolios. As explained inAppendix 3, country, sector, industry, and security selection decisions simply become moreimportant 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 farmore likely to be either up a lot, up a little, or down a little than it is to be down a lot in anygiven year. None of these first three scenarios warrants a defensive posture in our view. The firsttwo are positive, and up a lot happens much more frequently than down a lot. If we forecast up alittle or down a little this year, there’s a chance our outlook could be too tepid. If we reducedequity exposure, the opportunity cost relative to the benchmark could be very large in an up-a-lotscenario. Capturing big market up moves is essential to achieving long-term stock marketgrowth. Trying to sidestep small moves can easily undermine that goal.Another important consideration is the relative attractiveness of equities versus fixed income andcash alternatives. Entering 2011, we feel these alternatives are less attractive compared to stocksand not worth the potential opportunity cost. Interest rates on cash or cash-like instrumentsremain next to nothing. Fixed income alternatives are, in many cases, similarly low yielding andinterest rates across the board remain historically low. While we don’t believe interest rates willrise dramatically in 2011, even a small rise would depress prices. A modest year for stocksshould be superior to most alternatives this year.Past performance is no guarantee of future results. 11A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 13. Appendix 3: The Year of the “Alpha Bet”The last several years have been highlighted by sizable global stock market moves—up nicely in2007, down massively in 2008, up big in 2009, and up nicely again in 2010. Getting the directionof those moves right and betting on stock categories with appropriate betas largely determinedshort-term investing success. (“Beta” is a measure of how a stock or category moves relative tothe broader market.) All else equal, high beta categories tend to outperform in up markets andlow beta categories tend to outperform in down markets. Overweighting high beta categories likeEmerging 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 Staplesoutperformed in 2008. We believe 2011 will be a different type of year, with more muted overallreturns and “beta bets” playing much less prominent roles. Instead, making correct “alphabets”—determining how categories (e.g., country, sector, industry, and style) and securities willperform versus the broad market due to specific fundamental factors as opposed to broad macrofactors—will be more important this year.Fundamentals Regain PrimacyIn a new bull market, we believe returns are initially driven by a reversal of sentiment and influx ofliquidity. 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 ofthe bear market bounced the most (see Exhibit 5). That trend largely continued in 2010 (seeExhibit 6)—Financials, was a notable exception—but with less force and consistency than 2009.12 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
  • 14. 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 ConsumerSource: 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 ConsumerSource: Thomson Reuters. MSCI World Price Level Returns (USD).Past performance is no guarantee of future results. 13A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 15. We expect sentiment and liquidity forces to continue to give way to renewed investor focus onfundamentals in 2011. This process, however, won’t happen overnight—it’s more likely to be agradual transition. At present, we believe fundamentals favor certain Emerging Marketscountries 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 DispersionAnother stock market feature favoring “beta bets” over “alpha bets” in recent years has beenrelatively high correlations among stock categories and among individual securities withincategories. The recession, financial panic, and subsequent recovery were truly globalphenomena. 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 proportionof overall portfolio returns in 2011 than in recent years. In a year like this, “alpha bets” willdominate, and successful pickers of categories and stocks will likely win.The more granular internal components (industry and stock) have already shown increasingdispersion (see Exhibits 7 and 8), which we expect to grow and probably also lead to a drop incountry and sector level correlations. Once the trend toward higher dispersion begins, it tends topersist 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 2010Source: Thomson Reuters, 500 largest US stocks daily returns per quarter.14 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
  • 16. 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 2010Source: Thomson Reuters, S&P 500 weekly industry returns per quarter.Because of the forces described above, developing successful high-level investment themes waslargely sufficient in recent years. Correctly forecasting whether global economic growth wouldbe above or below expectations and emphasizing more or less economically sensitive categorieswent a long way toward beating the market. Similarly, overweighting Emerging Markets inaggregate has been about as effective as selecting individual Emerging Markets countries. Withlittle dispersion among and within categories, more narrowly focused themes were lessimpactful. In our view, beating the market in 2011 will require more focused portfolio themesand successful stock picking.Past performance is no guarantee of future results. 15A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 17. Appendix 4: Municipal Finance: A Coming Crisis or a ManageableChallenge?In light of recent weakness in the municipal bond market, many fear state and local governmentsmust choose one of two unattractive options—either making draconian fiscal adjustments ordefaulting on potentially hundreds of billions of dollars of debt. In many ways, muni fears are avariant of 2010’s PIIGS debt fears, but on a smaller scale and with a less ominous transmissionmechanism. Many people particularly concerned about municipal finances are the same whofretted the PIIGS in 2010—munis are just a new justification for their bearishness. And likePIIGS fears, muni debt concerns are likely overblown in the near term, and the threat isn’tsufficient 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 stockmarket discounts future economic conditions. Main Street’s jolt is coincident or slightly laggingas employment—a lagging indicator—recovers more slowly. Governments inherently feel arecession’s brunt and the subsequent recovery with a significant lag because tax receipts—theirprimary revenue source—are mostly collected after income is received. In every recession, taxrevenues across the board fall, and with every recovery, they rebound—this is normal. Most stateand local governments are likely to see funding gaps narrow over the next few years as taxrevenues rebound with the economy. And while some municipal bond issuers may face default inthe absence of a state and/or federal bailout, broader contagion is unlikely.Budget Gaps Are Already ClosingThe recent recession did indeed pressure state and local government finances. From Q2 2008 tothe Q2 2009, state and local tax revenue fell 9% as individual incomes and corporate earningsfell. Yet total spending remained flat—a reduction in discretionary spending was offset byaccelerating social benefits payments.v As a result, aggregate state budget gaps surged from $13billion in fiscal year 2008 to $117 billion in 2009 and $174 billion in 2010.vi Although thefederal government provided $192.9 billion in fiscal stimulus to states and local municipalities,viimany states had to cut budgets, draw down rainy day funds, or resort to accounting gimmickry tobalance their budgets.However, the situation has improved materially with the economic recovery. Tax receipts haverebounded 8.4% from their low and are now only 1.4% below pre-recession highsviii (see Exhibit9). And while social benefits payments continue to advance at a high single-digit rate, ongoingdiscretionary spending cuts have constrained growth in outlays overall.16 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
  • 18. 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 2010Source: US Dept. of Commerce, Bureau of Economic Analysis, National Income and ProductAccounts Table 3.3, State and Local Government Current Receipts and Expenditures (seasonallyadjusted at annual rates).Rising tax receipts have allowed states to narrow deficits and reduce borrowing activity. TheNational Conference of State Legislatures recently estimated state budget gaps are expected tofall to $111 billion in fiscal year 2011 and $82 billion in 2012.States also appear adequately positioned now to meet near-term financial obligations. Theaggregate debt-to-tax revenue ratio for state and local governments stands at 1.80 (see Exhibit10). This is above recent norms but below the levels seen through most of the 1980s and isalready trending down. Moreover, the aggregate tax-receipts-to-interest-payments ratio—ameasure 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).Past performance is no guarantee of future results. 17A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 19. 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 2006Source: US Dept. of Commerce, Bureau of Economic Analysis, National Income and ProductAccounts 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 tostate and city to city. It wouldn’t be surprising if some municipalities are unable to meet theirobligations—local defaults happen from time to time. In those situations, states typically supportmunicipalities—and the federal government could provide additional support at the state level. Infact, it would be near unprecedented for the federal government to allow a state to default. (Astate hasn’t defaulted since 1933, not because they haven’t been in financial distress, but becausethe federal government has eased the burden.)Muni Defaults—The Worst Case ScenarioEven if state and/or local governments are allowed to default, the magnitude of losses wouldlikely be relatively limited. Currently there is about $2.9 trillion in total outstanding municipaldebt—about 25% smaller than the amount of PIIGS debt and about one-fifth the size of the USmortgage market.ix $2.9 trillion is not a small number, but even if default rates hit the highestlevels 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 averageoutstanding 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,18 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
  • 20. muni principal and interest payments are typically deferred rather than canceled, so the ultimaterecovery rate is usually very high. Even during the Great Depression the recovery rate ondefaulted debt was about 99.5%.xi Assuming a similar recovery rate today, final losses formunicipal creditors would be only about $1.1 billion—or roughly 0.1% of the IMF’s estimate forwrite-downs on US mortgage loans and securities from 2007-2010.xiiEven if applying conditions from the single worst Great Depression year (1933)—whenmunicipal bond issuers defaulted on 16% of interest and principal payments—losses wouldlikely still be digestible. Municipal issuers now pay about $400 billion in interest and principalannually. 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 trillioneconomyxiii—and certainly not the hundreds of billions in losses many fear.Little Contagion RiskIn addition to being smaller in magnitude, the municipal bond market has far less financialcontagion risk than subprime or even PIIGS debt. During the credit crisis, the troubles in thesubprime market forced financial institutions to take capital losses on highly leveraged structureddebt instruments, which in turn forced them to sell assets at fire-sale prices to meet regulatorycapital requirements. These forced sales pushed asset prices down further, driving furtherdeleveraging—a rare, self-perpetuating cycle.This same cycle is unlikely with municipal bonds. Most of the debt (about 70%) is held byhouseholds 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 arefar 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. Butthat 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 inheadlines but are unlikely to be a major economic crisis.Past performance is no guarantee of future results. 19A risk of loss is involved with investing in stock markets. Phone: 800-568-5082Copyright © 2011 Fisher Investments. All rights reserved. Email: info@fi.comConfidential. For personal use only. Website: www.fisherinvestments.comJanuary 2011
  • 21. This review constitutes the general views of Fisher Investments and should not be regarded aspersonalized 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. Inaddition, no assurances are made regarding the accuracy of any forecast made herein. TheMSCI World Index measures the performance of selected stocks in 24 developed countries andis presented net of dividend withholding taxes and uses a Luxembourg tax basis. The S&P 500Composite Index is a capitalization-weighted, unmanaged index that measures 500 widely heldUS common stocks of leading companies in leading industries, representative of the broad USequity market. Past performance is no guarantee of future results. A risk of loss is involvedwith investments in stock markets.i Thomson Reutersii Thomson Reutersiii Thomson Reutersiv 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 2010vii Government Accountability Office; as of 12/31/2010. www.gao.gov/recoveryviii 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 1/11/11x Hemple, George H, “The Postwar Quality of State and Local Debt,” Published by the National Bureau of Economic Research, 1971xi Hemple, George H, “The Postwar Quality of State and Local Debt,” Published by the National Bureau of Economic Research, 1971xii 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-Q111012820 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
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