Outlook us-2011

Stock MarketOutlookIndependent Research & Market AnalysisPublished Quarterly by the Investment Policy Committee

2011: Part 1

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Past 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: [email protected]. For personal use only. Website: www.fisherinvestments.comJanuary 2011

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

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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: [email protected] Copyright © 2011 Fisher Investments. All rights reserved. Website: www.fisherinvestments.com Confidential. For personal use only.

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

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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�

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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

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

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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.

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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 (0% to +20%)

Up a Lot (+20% or more)

Down a Little (0% to -20%)

Down a Lot (-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.

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Exhibit 3: Third Year of a Bull Market

Bull Market Start Date

Initial 12 Months

Second 12 Months

Third 12 Months

Total Bull 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.

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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

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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:

� An ongoing economic expansion will likely meet or exceed expectations globally � Corporate profits on average should continue beating expectations� Stock valuations remain attractive relative to bonds � Monetary policy remains highly accommodative almost everywhere � US tax cut extensions diminished fiscal policy risks � Political gridlock is increasing globally � 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

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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

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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.

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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.

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-66%-50% -48% -45% -41% -36% -35% -34% -33% -32%

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Exhibit 5: Sector Bounce Theme 2009

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

Exhibit 6: Sector Bounce Theme 2010

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

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

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 ��

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

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Exhibit 8: Intra-Industry Correlation Decreasing

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.

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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.

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$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

-10%

-5%

0%

5%

10%

15%19

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

($Billions)Ye

ar-o

ver-

Year

Cha

nge

Billions of Dollars

Year-over-Year Change

Exhibit 9: State and Local Government Tax Receipts

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).

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January 2011�

-

1

2

3

-

10

20

30 19

51

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

2006

Total Debt to / Tax R

evenueTa

x R

even

ue /

Inte

rest

Pay

men

ts

Tax Receipts / Interest PaymentsTotal Debt / Tax Revenue

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.

Debt service costs are a smaller percentage of tax revenue than they have

been for most of the last 30 years.

Exhibit 10: Financial Leverage Ratios for States and Local Governments

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,

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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.

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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/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 1/11/11 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.

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