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Unformatted text preview: 2010 STOCK MARKET OUTLOOK, PART I Executive Summary The MSCI World Index gained 4.1% in Q4, 30.0% for the year, and 73.0% since the March 9th bear market bottom.i While the stock market is well below its 2007 all-time high, 2009 was an encouraging beginning to a new bull market. We expect global stocks to gain more than average (>10%) in 2010 but probably less than the 2009 return (<30%). 2009 played out almost exactly as we foresaw. The initial rebound essentially mirrored the late bear market decline almost perfectly, fulfilling our V-shaped bounce forecast. Categories that fared worst at the end of the bear bounced back most, including Emerging Markets, Materials, Technology, and Consumer Discretionary stocks. 2009 concluded an unusual decade bookended by two big bear markets, leaving stock indexes with little to no net gain for the period.ii Some reflexively herald a “new normal” going forward—a period of sluggish economic growth and restrained stock returns. Though rare, 10year periods of flat or negative returns historically have been followed by periods of strong returns—both in the US and globally. But rather than dwelling on unactionable long-term predictions, we forecast one year forward, and 2010 should play out like a typical second year of a bull market. As far back as we can measure (more than 100 years) US stocks have been consistently positive the second year after a huge bear decline—overwhelmingly so. (The sole exception was the second year after the 1932 bottom—the S&P 500 fell a mere 0.4% before resuming a steep upward trajectory for the next three years.)iii Surging liquidity and rebounding sentiment drove 2009’s gains. Revenue and earnings growth should instead be paramount in 2010, with sentiment a secondary feature. Top-line growth will likely stem from two main forces. First, the largest emerging economies will almost undoubtedly increase consumption as their populations move further up steep parts of the development curve. Second, business investment should rebound as companies play catch-up after skimping on capital expenditures and inventories during the last 18 months. Both forces will bolster global trade, as we’ll discuss in Appendix II. Governments may be massively bloated, but public companies are overwhelmingly lean and mean. Non-bank cash balances are at all-time highs, borrowing costs are low, and productivity is hyperefficient following extraordinary cost-cutting actions. The net effect: huge earnings growth, especially when compared to depressed prior year results. Additionally positive, the major central banks will in all likelihood keep credit conditions easy through most of if not the entire year, and 2009’s huge fiscal programs’ stimulatory effects will be more meaningfully felt as more of the previously appropriated funds is actually deployed. Very little has been spent so far, but we expect that changes fast immediately ahead. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 1 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Despite last year’s huge advance, sentiment remains starkly skeptical, which is good—bull markets thrive on the proverbial “wall of worry.” Perhaps more precisely, there’s what we have come to call a broad spectrum “pessimism of disbelief”—how can markets do well with so many problems in the world? Bad things are seen as bad and good things are seen as likely to turn bad. Prevalent concerns include monetary and fiscal stimulus exit strategies, health care and regulatory reforms, US midterm elections, inflation, unemployment, commercial real estate, geopolitical troubles, and a general disgust with all things political. In Appendixes III and IV, we’ll address these and other issues. Though stocks should be nicely positive overall, a short-lived correction would be normal at some perfectly random time in the second year of a bull market. But, then too, it might not happen, as it didn’t happen in the second or third years of the last bull market. These things get very random. Corrections usually have a singular fantastical storyline that appears suddenly out of nowhere, causing fear to skyrocket, and is quickly forgotten after the resulting short, sharp selloff ends and the fantastical storyline is recognized as a pure fantasy. Anticipating exactly when one will occur is nearly impossible, and we don’t ever attempt to sidestep these fleeting downturns for fear of getting whipsawed. In regard to portfolio tactics, the categories that led during the initial bounce should still lead into early 2010. However, as the bull market matures and new fundamental trends emerge, a change in leadership among categories is likely, requiring some material portfolio realignment, though this rotation is doubtful in the first quarter—more likely later in the year. We are far into the contemporary market research to determine specifically which categories will lead that next phase. The Investment Policy Committee Ken Fisher, Jeff Silk, Andrew Teufel 2 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Table of Contents Appendix I: The Bull Continues A Look Back Stocks Are Better Than Bonds. Again. Gold Fever Recession Likely Over 4 5 6 7 7 Appendix II: The Bullish Case The Second Years of Bull Markets Three Pillars of Economic Expansion Earnings Growth Valuations Are Attractive Monetary and Fiscal Policy Tailwinds Sentiment Remains Highly Skeptical Expect a Change in Leadership and Portfolio Shifts Be Prepared for a Bull Market Correction 8 8 9 12 13 14 14 15 15 Appendix III: Pessimism of Disbelief The Exit Strategy Inflation Debt and Deficits Commercial Real Estate—The Next Shoe to Drop? Unemployed Consumers Won’t Spend Sovereign Debt Crises US Politics Geopolitics and Terrorism 16 16 17 18 19 20 21 21 22 Appendix IV: Politics at Home and Abroad Health Care and the Elections US Political Will Up Against a Wall A Global Shift? Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 23 23 23 24 3 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Appendix I: The Bull Continues Global stocks rose 4.1% in the fourth quarter, capping off a massive 73.0% surge from the March bottom, resulting in a terrific 2009—the MSCI World Index gained 30.0% and the S&P 500 rose 26.5%.iv Though the global stock market is still below its all-time high in 2007, it was an encouraging start to a new bull market. (Exhibit 1) Our 2009 forecast played out almost exactly as we foresaw. The steep initial rebound almost exactly matched the final descent of the bear market, fulfilling our V-shaped bounce forecast. Though initial returns were unusually big, in many ways it was a prototypical V bottom with returns driven largely by liquidity and sentiment. Because the 2008 bear was historically big and steep, the V bounce should continue at least partially into 2010, helping make it a nicely positive year with above average returns, though not as big as 2009—or between 10% and 30%. Exhibit 1: MSCI World Index Performance 2009 2,900 MSCI World Index Net Return (USD) 2,700 2,500 2,300 2,100 1,900 1,700 1,500 Mar-09 Jan-09 Jun-09 Oct-09 Jul-09 Nov-09 May-09 Aug-09 Dec-09 Sep-09 Feb-09 Apr-09 Source: Thomson Reuters; as of 12/31/2009 4 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. A Look Back Tied to rebounding sentiment, we forecasted those categories that performed better earlier in the bear but fell most relative to the market in the later stages should bounce back most in the new bull. Those categories included Industrials, Materials, Consumer Discretionary, Tech, and Emerging Markets. Exhibits 2 and 3 (following page) show sector and regional performance six months to the March bottom and from the bottom through yearend. Almost perfectly, those categories that fell most bounced most. Note that, as indicated by our bounce theme, Emerging Markets stocks performed best. Their economies on balance have also led the economic recovery. This serves as a reminder to think globally. Recoveries need not be US-led to be robust. And failing to look at the non-US world could have meant missing a sizable portion of the rebound. Exhibit 2: Bounce Theme—Sectors 140% 125% MSCI World Sector Price Level Returns (USD) 120% 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% -66% -50% -48% -45% -41% -36% -35% 77% 96% 75% 79% 03/09/09 - 12/31/09 09/09/08 - 03/09/09 49% 36% 48% 40% 45% -34% -33% -32% Utilities Consumer Discretionary Source: Thomson Reuters; as of 12/31/2009 Consumer Staples Health Care Energy Industrials Technology Financials Materials Telecom. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 5 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Exhibit 3: Bounce Theme—Regions 120% 118% 100% 80% 03/09/09 - 12/31/09 09/09/08 - 03/09/09 Price Level Returns (USD) 60% 40% 20% 0% -20% -40% -60% -62% 73% 64% -47% -44% -80% Emerging Markets Source: Thomson Reuters; as of 12/31/2009. *10/27/2008 used as bear market bottom for Emerging Markets; Last six months in the bear is 4/27/2008-10/27/2008 and the subsequent return is 10/27/2008-12/31/2009. Though Financials performed best overall from the bottom, a big portion of that outperformance came in a short period at the very beginning of the bull market, which would have been treacherous to time. Starting in May, Financials largely traded in line with the market and then began underperforming the market in the fourth quarter. Cumulatively since May, Financials have lagged, v facing a glut of new stock supply from recapitalizing firms, ongoing controls, and uncertainty from new pending regulation. In analysis of past bear markets, it’s not unusual to see the big single sector that led the bear market down the whole way bounce big initially, but then lag, sometimes for years, as investors keep fighting the last war. Stocks Are Better Than Bonds. Again. Following a miserable 2008, stocks outperformed similarly liquid asset classes in 2009 by a wide margin. Many investors tend to forget that bonds, even US Treasuries, can and do lose value. Bonds not only suffered relatively compared to stocks in 2009, but also on an absolute basis, as 10-Year US Treasuries lost 9.5%.vi Government bonds suffered globally as well, with flat or slightly down returns in the UK, Canada, Japan and Germany.vii Corporate bonds, by contrast, turned in respectable gains, and high-yield (aka junk) bonds performed extremely well. 6 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Developed ex USA Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. USA Gold Fever Another asset class that lagged stocks in 2009 was gold—returning 24.8% to stocks’ 30.0%viii— which may surprise many since gold was such a popular media topic. Gold’s long-term returns also lag stocks. Since gold began trading freely in 1973, following post-Bretton Woods controls, it’s returned a cumulative 983% (annualized 6.8%). Meanwhile, global stocks returned 2,229% (9.1% annualized) and US stocks 3,552% (10.5% annualized).ix Further, much of gold’s long-term return came in very brief boom periods. There have been 6 major gold booms since 1973, each lasting anywhere from 4 to 22 months—representing 15% of the total time. (Contrast this with stocks, which tend to rise more than fall.) Absent these periods, gold annualizes negative returns (-3.6%),x making gold inherently a short-term timing game. Failing to hit gold booms spot-on accurately on either end means holding an asset that can sag sideways and down for long periods. Recession Likely Over Though the recession’s end won’t be officially dated for some time, most of the developed world returned to growth by Q3 2009. Emerging economies mostly returned to robust growth even earlier. Growth is projected for most regions in 2010, with Emerging Markets still leading (Exhibit 4). Individual trouble spots will exist, which is normal even during the healthiest times, but shouldn’t drag on continued global growth. Exhibit 4: Projected Growth Rates of Top GDP Countries Country United States Japan China Germany France United Kingdom Brazil India South Korea Other Emerging Markets Total Emerging Markets % of 2008 World GDP 23.7% 8.1% 7.1% 6.0% 4.7% 4.4% 2.6% 2.0% 1.5% 11.9% 25.1% 2010 Projected GDP Growth Rate 2.7% 1.5% 9.6% 1.7% 1.5% 1.4% 5.1% 7.7% 4.7% 3.7% 5.9% Source: IMF, Thomson Reuters, Consensus Economics Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 7 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Appendix II: The Bullish Case The early stage of the new bull market was driven primarily by rebounding sentiment and a global wall of liquidity from stimulus programs—unprecedented in their size and coordination. Those forces remain in place, but fundamentals should gain primacy as the year progresses. With that in mind, we explain the following bullish drivers in this appendix: There is an overwhelming historic precedent for another positive year. Fast-growing Emerging Markets, a business investment rebound, and resurging global trade will drive economic growth. Extremely lean corporate expense structures will allow recovering revenue to translate into outsized earnings growth. Stock valuations are still quite cheap given the low interest rate environment. Monetary and fiscal policies continue to provide strong tailwinds. Sentiment remains highly skeptical. The Second Years of Bull Markets Historically, after a bear market-sized decline and a positive year, the next year is almost always positive. As far back as we can measure, the second 12 months after a huge bear decline have been near uniformly positive for US stocks. The one exception was after the 1932 bottom, when stocks fell just 0.4% before resuming a steep upward trajectory for the next three years.xi Other than that, returns have been positive and mostly above average. 8 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Exhibit 5: S&P 500 Total Return After Bear Market Bottoms Bottom 6/30/1877 1/31/1885 8/31/1896 10/31/1903 11/30/1907 10/31/1914 12/31/1917 6/30/1921 6/1/1932 4/28/1942 6/13/1949 10/22/1957 6/26/1962 10/7/1966 5/26/1970 10/3/1974 8/12/1982 12/4/1987 10/11/1990 10/9/2002 Average Source: Global Financial Data, Inc. Initial 12 Months 31.5% 29.0% 29.8% 29.3% 48.8% 45.2% 25.6% 38.9% 134.8% 63.9% 52.0% 36.4% 37.2% 37.3% 48.9% 44.5% 66.1% 26.0% 33.7% 36.2% 44.7% Second 12 Months 22.1% 11.3% 15.0% 25.0% 20.3% 14.8% 20.7% 1.2% -0.4% 8.8% 20.1% 13.2% 21.0% 10.0% 14.5% 26.0% 6.8% 33.9% 8.9% 9.9% 15.2% Three Pillars of Economic Expansion Global economic growth will likely come from three main sources. First, Emerging Market economies, already cumulatively bigger than the US economy (Exhibit 6, following page), are leading the world out of recession. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 9 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Exhibit 6: US, Developed World, and Emerging Markets—Percent of World GDP Country United States Japan China Germany France United Kingdom Brazil India South Korea Other Emerging Markets Total Emerging Markets % of 2008 World GDP 23.7% 8.1% 7.1% 6.0% 4.7% 4.4% 2.6% 2.0% 1.5% 11.9% 25.1% Source: IMF, Thomson Reuters, Consensus Economics Already in the nascent recovery, consumption gains in the largest emerging economies have largely offset the developed world’s recessionary decline. But even beyond their cyclical recoveries, secular growth trends will almost undoubtedly drive consumption in the largest emerging economies significantly higher because big chunks of their populations are moving up steep parts of the development curve. In particular, China, India and Brazil have huge portions of their populations moving into (and beyond) per-capita income levels highly correlated with major consumer goods purchases and living standard improvements. For instance, automobile ownership penetration surges at approximately the $5,000 income level. Exhibit 7 (following page) shows even modest income growth should yield wildly better unit sales in many of the fast-growing countries. 10 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Exhibit 7: Auto Penetration Versus Per Capita Income 1,000 900 Vehicles Registered per 1000 persons 800 700 600 Spain France United States United Kingdom 500 400 300 200 100 0 C hina India Russia Brazil Korea $0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000 Per Capita Income Source: World Bank Second, business investment should rebound sharply as companies play catch-up after skimping on and, in fact, savagely slashing capital expenditures and inventories during the last 18 months. US private investment (mostly business spending) fell 27.4% peak to trough during the downturn,xii leaving it significant room to rebound. Just as the categories that fell the most in the bear have bounced the most in the new bull market, so too should segments of the economy that declined the most experience the biggest positive reversal—and business investment best fits that bill. Contrary to popular sentiment, firms are exceptionally healthy, particularly relative to past recessions, and in a good position to capitalize on the rebounding economy. Non-bank firms’ cash balances are at all-time highs—S&P 500 firms (ex-Financials) have about $950 billion on hand—approximately 12% of the S&P’s total market cap.xiii Large cash balances set the stage for future investments in technology upgrades, research and development, infrastructure spending, acquisitions, dividends, and so on—all are positive for stocks and the economy and exceedingly bullish. Not only are firms cash-rich, but borrowing costs are at historic lows and credit spreads continue to narrow from 2008’s crisis levels, amid normalizing credit conditions on the whole. Third, both strong emerging market growth and resurgent business investment should bolster global trade, which also fell severely during the recession. (Exhibit 8, following page) Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. $80,000 11 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Exhibit 8: US Economic Trends $165 $155 $145 $135 $125 $115 $105 $95 Government Spending Personal Spending Exports Q1 2003 = $100 Business Fixed Investment Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Source: Bureau of Economic Analysis; Q3 2009, third estimate Earnings Growth Lean cost structures also give firms tremendous operating leverage, which should translate even small revenue gains into significantly higher earnings. While past downturns have seen a rise in productivity, this time around cuts were far more drastic and the productivity rise more dramatic. Consensus earnings forecasts call for 29% earnings growth for S&P 500 companies in 2010.xiv This might seem outlandish, but such large increases have occurred on numerous prior occasions, especially and usually following periods of huge earnings declines like 2007-2008. We expect actual earnings to beat the consensus forecast. (Exhibit 9, following page) They almost always have after every recession. 12 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Q1 2009 Exhibit 9: Earnings Growth Outlook Calendar Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Average 2010 Consensus Estimate S&P 500 Earnings Growth 42.6% 11.8% 13.0% 3.9% -3.8% 28.0% 3.3% -50.5% 11.8% 75.2% 20.8% 19.4% 16.5% -18.4% -76.6% 6.5% 6.5% 29.4% Source: Standard & Poor’s, Thomson Reuters; Basic earnings per share excluding extraordinary items. Earnings growth for 2009 and 2010 are forecasts. Valuations Are Attractive Earnings yields (the reciprocal of P/Es) on stocks remain well above comparable bond yields, meaning valuations remain attractive. (Exhibit 10) Exhibit 10: How the Market Can Get to Parity MSCI World Index Level…………………………………. MSCI World Expected 2009 EPS………………………. MSCI World Earnings Yield……………………………… 10-Year Treasury Yield…………………………………… To reach parity, either: The MSCI World could rise…………………………… or the 10-Year Yield could rise………………………. or the MSCI World EPS could fall…………………… or a combination of any of the above 1168 $82.45 7.1% 3.5% 101.2% 3.6% -50.3% Source: Thomson One Analytics, Bloomberg Finance L.P., IMF; as of 12/31/2009 Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 13 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Monetary and Fiscal Policy Tailwinds While not a primary driver of returns as they were last year, liquidity-bolstering monetary and fiscal policy remains constructive. Major central banks will likely maintain highly accommodative policies for much, if not all, of the year ahead—giving recovery the time to gain traction. Some tightening can be expected, but should be seen as a symptom of improving economic conditions. Further, as interest rates globally are exceptionally low, rates can rise quite a bit and still be within historic norms. Further, the massive fiscal stimulus programs enacted in early 2009 are still not yet fully deployed and their impacts yet to be felt. In the US alone, just over 32% of the $787 billion allotted had been paid out through yearend. Some nations were faster deploying stimulus funds, but globally, there is still a massive amount of stimulus to be spent. Yet now it just fuels the expansion faster. Exhibit 11: Total Stimulus Funds Available Versus Paid Out $350 $288 B $300 $250 $275 B Funds Paid Out Total ARRA Funds $224 B ($ Billions) $200 $150 $100 $50 $0 $92.8 B $68.5 B Contracts, Grants, Loans $95.7 B Source: US Treasury, Federal Agency Financial and Activity Reports; as of 12/31/2009 Sentiment Remains Highly Skeptical Though our outlook is positive, news won’t be. The Wall Street adage “bull markets love to climb a wall of worry” is as pertinent as ever. The panic conditions of 2008 have subsided, but sentiment remains beyond skeptical. This is bullish. In Appendix III, we explore the particular strain of skepticism that pervades today’s marketplace, which we have labeled “the pessimism of disbelief.” 14 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Entitlements Tax Benefits Expect a Change in Leadership and Portfolio Shifts While the forces that drove the V-bounce theme likely carry effectively into early 2010, we expect some category leadership changes as liquidity and sentiment give way in primacy to fundamentals. As a result, we anticipate making portfolio shifts as the leadership changes occur. These changes likely won’t happen in Q1 but instead later in the year—perhaps much later. It is too early now to know. We are well into our market research to determine which categories are best positioned to lead the bull market’s next phase and how that will transition. How the leadership changes occur will depend largely on how market conditions evolve. In past bull markets, we’ve seen examples of both a rapid change in leadership, and a more gradual phasing in. We are vigilant for signs of both. Be Prepared for a Bull Market Correction A short-lived correction would be typical—even expected—at some perfectly random time in 2010. Bull market corrections are short, sharp drops usually coinciding with a fantastical storyline that appears suddenly out of nowhere, causing fears to skyrocket. Though a correction isn’t unexpected it also isn’t necessary. It wouldn’t be unheard of for one not to occur since one didn’t in the second or even third year of the last bull market. Regardless, we wouldn’t attempt to maneuver around it for fear of being whipsawed. Corrections typically end as quickly as they come as the storyline is finally recognized as silly or insignificant and the market resumes its march upward. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 15 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Appendix III: Pessimism of Disbelief Sentiment remains skeptical despite 2009’s massive market advance. Dour sentiment is normal and in fact bullish—this is the proverbial “wall of worry” stocks love to climb. More precisely, we call this a “pessimism of disbelief”—the view markets can’t rise when there are so many problems in the world. Bad news is bad, but good news is seen as either wrong or likely to morph into something bad. For example, there is tremendous fear of a weak economy but there is also fear that stimulus efforts either won’t work or, whether they work or not, they will cause bad features like massive inflation, a wall of debt for future generations, and the impetus behind increasing socialism. All is bad, but the remedy is seen as likely impotent or bad as well. That is the core of the pessimism of disbelief. Overall, professional market forecasters are mildly bullish, expecting mostly below-average positive returns and weak global recovery. In our view, their expectations are too meager and based on fears not likely to have the market impact they expect. We’ve detailed some of 2010’s likely prominent concerns in this appendix. The Exit Strategy A prominent fear that surfaced in 2009 and should continue through 2010 is the world’s central banks will choke off the nascent economic recovery with a too-early or too-sudden exit from monetary stimulus. However, though the stimulus was massive and coordinated globally, the reversal will likely not be sudden, but driven instead by conditions as they allow in individual nations. Further, many emergency measures were short-term by design and will wrap up naturally on their own without any extraordinary measures. Some tightening is already occurring in China as its economy has returned to brisk growth— though steps taken thus far, like a 4 basis point increase in a key banking rate in January, have been relatively minor. Australia’s Reserve Bank began the first of three consecutive monthly interest rate hikes in October on improving economic conditions. Other nations have taken some measured steps or have released tentative plans for their own exit strategies—and stocks globally have continued climbing. And though some initial tightening measures may continue, most nations have voiced plans to remain accommodative through 2010. Further, though many believe central bank rate raises choke off stock rallies—that’s not been so before. Exhibit 12 (following page) shows S&P 500 returns 12, 24, and 36 months after the initial rate rise in Fed tightening cycles, and returns are overwhelmingly positive. Further, keep in mind we have not yet seen the first rate hike in America. Also, interest rates globally are overall exceptionally low—they could rise even quite a bit from here and still be historically low. And some of those rate hikes started from much higher levels with monetary conditions already much tighter. 16 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Exhibit 12: S&P 500 Following the First Rate Hike Date of First Fed Funds Hike 7/16/1971 8/16/1977 10/21/1980 3/27/1984 12/16/1986 3/29/1988 2/4/1994 6/30/1999 6/30/2004 AVERAGE 12 Months 7.8% 7.1% -8.9% 14.1% -0.8% 12.4% 1.9% 6.0% 4.4% 4.9% 24 Months 6.6% 10.6% 5.5% 51.9% 10.5% 31.0% 35.3% -10.8% 11.3% 16.9% 36 Months -16.4% 28.6% 25.9% 88.3% 40.0% 44.3% 68.0% -27.9% 31.8% 31.4% Source: Federal Reserve, Global Financial Data, Inc. Price level returns. Even the broadly telegraphed end to the Fed’s $1.25 trillion mortgage-backed securities purchase program, set to end March 31, may not mark the end of federal underwriting of the mortgage market. On Christmas Eve, the Treasury Department quietly lifted the cap on lending available to Fannie Mae and Freddie Mac. This opens the door for those government-sponsored entities to buy an unlimited amount of mortgages and mortgage-backed securities. While of questionable long-term wisdom, in the short run there is the potential to inject almost infinitely more liquidity into the mortgage market. Inflation Consistent with the pessimism of disbelief, many investors fear a too-early exit strategy but simultaneously fear rising inflation. Given the unprecedented amount of global monetary stimulus over the past 18 months, higher inflation is an elevated risk if global central banks don’t act appropriately in reining in excess liquidity when the time comes. However, in our view, this risk is still a long way off. Firms still don’t have much pricing power: Unemployment, though starting to improve, is still very elevated, and capacity utilization is still relatively low (Exhibit 13, following page). Firms raising prices could easily be undercut by competitors—making price moves ineffective, feckless, even unwise. Also, inflation can be offset by productivity gains—and firms made extraordinary gains in productivity in the most recent downturn (see Appendix II). Further, recall that until recently, deflation was an immediate and serious risk, so a little inflation at this point wouldn’t be alarming and might even be reassuring to many—just a little. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 17 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Exhibit 13: US Capacity Utilization 90 85 Capacity Utilization (%) 80 75 70 65 Oct-89 Oct-90 Oct-91 Oct-92 Oct-93 Oct-94 Oct-95 Oct-96 Oct-97 Oct-98 Oct-99 Oct-00 Oct-01 Oct-02 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Source: Federal Reserve, Thomson Reuters Though monetary policy is never perfect and the Fed made serious errors we wish they hadn’t, they did prove innovative in responding to frozen credit markets, injecting liquidity through a variety of new facilities. They may prove similarly innovative in reversing the stimulus. Already, the Fed has announced a proposal to sell interest-bearing longer-term deposits. This new facility is intended to encourage banks to park their reserve deposits at the Fed, allowing the Fed to drain some money supply, adding to its inflation-fighting arsenal. Realize too that some of the newly created liquidity will be permanently, and necessarily, kept in the system due to more stringent capital requirements and the subsequent reduction in money velocity. And the Fed’s new ability to pay interest on reserves makes the potential inflationary pressure of higher money supply levels a more easily manageable challenge. Debt and Deficits Also, as stated earlier and consistent with the pessimism of disbelief, investors fear a slow economy while at the same time fearing the fiscal stimulus. An argument is fiscal stimulus hasn’t worked, so why bother. Or additional spending adds to debt and deficits, causes inflation, and leads to socialism. In the past, we’ve shown why fears that America’s deficits are too big and the country overindebted, while not necessarily wrong, are misconstrued. Currently, America’s net public debt is 18 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Oct-09 approximately 54% of GDP.xv It’s elevated tied to the unprecedented fiscal response to the credit crisis and slowing economy, but still lower than it was during any time between 1943 and 1956—a period marked by fine growth and stock returns overall. Also, it’s just slightly higher than from 1992 to 1998—an exceptionally fine time for stocks. Further, historically low interest rates make paying for our nation’s debt very cheap. Exhibit 14 shows America’s debt servicing costs—currently approximately 2% of GDP. Despite having more actual debt, paying for it costs less relative to the size of the economy than it did any time between 1979 and 2003. Just to get to the level it was during half of the 1980s and most of the 1990s, interest rates must rise 200 basis points.xvi Even if they did, recall the 1980s and 1990s were overall fine times for the US economy and stocks. And finally, Britain had two to three times this debt load as a percent of GDP for over 100 years during its heyday as a global power in the late 18th and 19th centuries. If they could then, we certainly could now. Exhibit 14: US National Debt Servicing Cost 6% 5% Interest Payment / GDP Debt increases 50% and rates move 200bps higher Rate move 200bps higher 4% 3% Debt increases 50% 2% Rates move up 100 bps 1% 1979 0% 2003 Q3 1989 Q1 1992 Q3 1994 Q1 1997 Q3 1999 Q1 2002 Q3 2004 Q1 2007 Q3 2009 Q1 1952 Q3 1954 Q1 1957 Q3 1959 Q1 1962 Q3 1964 Q1 1967 Q3 1969 Q1 1972 Q3 1974 Q1 1977 Q3 1979 Q1 1982 Q3 1984 Source: Federal Reserve Flow of Funds, BEA, US Treasury, Thomson Reuters (Q1 1952 – Q3 2009) Commercial Real Estate—The Next Shoe to Drop? Many fear the fallout from the credit crisis has yet to broadly hit commercial real estate and there’s a “second shoe” waiting to drop. Maybe, but if so, it is a much smaller shoe. Keep in mind the commercial mortgage universe is smaller than the residential, about 25% as big— there are currently $10.9 trillion in residential mortgages outstanding, but only $2.5 trillion in commercial mortgages.xvii Further, the commercial real estate shoe has already largely dropped, without any widespread ill effect. Many of these loans have already been written 19 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Q1 1987 down by the holding banks, thus accounting for their losses. And banks engaged in commercial real estate lending are largely prepared with excess reserves, having witnessed well what happened to their residential counterparts. Likewise, commercial mortgage-backed securities tanked simultaneously with their residential counterparts back in 2008. Finally, the FAS 157 effect fully hit the commercial and residential markets in 2008 through early 2009—over and done. So this shoe would be much smaller. There’s also the fear that already embattled big banks, though having mostly paid back TARP funds, can’t deal with another round of mortgage losses. However, lenders with significant exposure to commercial real estate are a different set of banks—mostly small regional banks. America’s 10 largest banks have 48% of total US banking assets, but commercial mortgages average just 6% of their total loan portfolios. The next 8,000 banks have 52% of the US’s banking assets, but average 20% exposure to commercial mortgages in their loan portfolios.xviii It’s a different kettle of fish. While some of these smaller banks may be adversely affected by loan losses, this should have little impact on overall financial system stability. And smaller troubled banks are much easier to deal with in crisis—in the traditional ways they always have been, leading them to be acquired by bigger banks. Unemployed Consumers Won’t Spend US unemployment ended 2009 at 10%—and it should stay elevated for some time. While many fear this will stall economic recovery, the reverse is true. Unemployment historically lags recovery in every US recession we can measure—and in other countries too. It’s normal. Growth should lead to increased hiring, not the reverse. This isn’t counterintuitive—firms reduce spending in an economic downturn (or in anticipation of one), including on personnel. This is why recessions typically see big productivity gains as firms learn to make do with less. Lean cost structures mean firms can start seeing big earnings increases, even on slim revenue gains early in a rebound. It’s not until after sales start recovering markedly that most firms will return to hiring—which they do very slowly and carefully—which is why the economy can pick up well before unemployment starts falling. Unemployment fears are linked to fears consumers can’t recover enough to help drive future growth. Consumer spending is a big portion of our economy—approximately 71% of US GDPxix—but is far more stable relative to other components. Government and private investment (mostly business spending), net exports, and residential construction are much more variable than consumer spending and typically fall more in recessions. (See Exhibit 8 in Appendix II.) From the peak of real economic output in Q2 2008 through the low in Q2 2009, real consumer spending fell 1.7% while the US economy overall shrank 3.8%.xx By Q3 2009, consumer spending had rebounded 0.7%.xxi And because consumer spending is more stable, it typically grows as a percent of GDP during recessions as other components fall. (Exhibit 15, following page) This time was no exception. Also, we anticipate the big consumption increase will happen not as much in America, but in the big emerging economies, as described in Appendix II. 20 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Exhibit 15: Consumer Spending as Percent of GDP Grows in Recessions 72% 70% 2000-01 68% '91 66% '80-'81 64% '73-'74 62% 60% May-53 May-67 May-81 May-95 Source: Bureau of Economic Analysis; Thomson Reuters Sovereign Debt Crises In the fourth quarter, a few sovereign debt crises (or near crises) sparked fears regional trouble could stall global recovery. Dubai World—a holding company run by the Dubai government— nearly had to defer debt payments for several months until neighbor Abu Dhabi guaranteed their debt. Then Greece ran afoul of European Monetary Union (EMU) deficit levels and faced credit downgrades based on the size of its debt—sparking fear of bankruptcy. An EMU member nation defaulting could have serious implications for the continued existence of the euro (though for now, other member nations have voiced commitment to maintaining the union). Keep in mind, during the best of times there have always been individual trouble spots. Some individual nations struggling to recover shouldn’t drag on overall global growth. Consider: Scaled properly, Greece’s GDP (output of new goods and services) is less than Wal-Mart’s annual revenue (output of new goods and services). The two concepts are fully comparable. US Politics With a health care reform battle still brewing and an active legislative agenda still on the table, many fear the fallout from a pending cap-and-trade bill, financial regulatory reform, tax hikes, sun-setting tax cuts, and so on. We deal with political issues and their likely market impact in Appendix IV. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. May-09 21 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Geopolitics and Terrorism Fears surrounding ratcheting tensions between Iran and Israel died down by yearend 2009, but we anticipate geopolitical tensions will continue to flare periodically—whether in that region or any other. Geopolitical disruptions are impossible to forecast—but they are also a constant through history and have been for millennia. As for potential market reactions to a large-scale, unexpected geopolitical events, history can serve as a guide. In the period immediately following the major terrorist attacks of 9/11, the S&P 500 dropped over 11% by September 21—but then took only 20 days to recover and continue trading above September 10 levels for months thereafter before resuming the bear market that had begun long earlier. This trend was also observed in the S&P 500 after terrorist attacks in Madrid and London in 2004 and 2005, respectively—with the recovery taking even less time. Simply, while geopolitical events might disrupt markets in the near term, they’ve shown no ability to derail markets from longer-term trends, and the ongoing costs associated with constantly hedging against such events far outweigh the fleeting benefits. 22 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Appendix IV: Politics at Home and Abroad As always, our political analysis is agnostic by design—we’re typically equally hard on Republican and Democrat politicians. Because legislation—actual or the threat of—can influence stocks, our primary objective is to determine how a given political event may impact capital markets. New legislation usually results in the redistribution of money and/or property rights. Because investors dislike loss more intensely than they enjoy gain, just the prospect of new major legislation can spike risk aversion, negatively impacting stocks. Stocks usually prefer legislative status quo—therefore, usually so do we. Health Care and the Elections It appears, with the special election of Senator Scott Brown (R-MA), the health care bill’s health is itself doomed, as he ran vowing to be the “41st vote” against the bill. Still, the Democrats could push the bill through in a budget reconciliation process, which requires a simple majority. But that or any other parliamentary tricks would only compound their woes come election time—and likely many of them know it. Understandably, there’s heightened interest surrounding mid-term elections this year. It’s tempting to conflate recent events (governor elections in NJ and VA, congressmen retiring and changing parties, etc.) as bellwethers for November, but elections are a long way off, and much can happen before then. One thing we can say now is it’s all but certain Democrats lose still more relative power. The sitting president’s party typically loses 25 House and 2 to 3 Senate seats on average in midterms. Whether losses this year will be above or below average remains to be seen, though it’s likely linked to how much more material legislation the Democrats attempt. The more they attempt to pass, the more they will likely suffer at the polls. Typically as mid-terms loom, politicians become loathe to pass much, as they don’t want to annoy valuable swing voters. Further, certain key legislation left unpassed can serve as a useful wedge issue for politicians to predicate fund-raisers on and rally their base. That the health care reform bill survived as long as it did, looking near-certain to pass, was simply amazing to us. Perhaps equally amazing as a Republican winning a Massachusetts Senate seat. But this is perhaps reminiscent of Newton’s third law of motion—that an action results in an equal-sized reaction—and politicians will somehow find a way to moderate in anticipation of an election. US Political Will Up Against a Wall Whether the Obama administration and the Democrats continue pursuing their key initiatives will depend on whether they’ve learned anything from this exercise. If they haven’t, they may continue full speed ahead—and that could be a potential negative for stocks as well as result in a Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 23 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com bigger loss of relative power. If they have learned, they’ll likely find any number of excuses to refrain from passing much—at least not unless it’s effectively toothless—to stanch potential losses. That, combined with the huge increase in government spending throughout the recession, should have political will hitting a wall later this year. Exhibit 16 provides a brief overview of currently pending major legislation and our view of its likely outcome. Exhibit 16: Pending US Legislation Pending Legislation Sweeping financial system regulatory reform Likely Outcome Senate Banking Committee Chairman Christopher Dodd spearheaded a proposal of a sweeping financial regulatory reform. However, his announced retirement will table the bill in its current form. Any further legislation will require significant compromise, and probably gets punted down the road. The Waxman-Markey “cap-and-trade” bill passed the House last summer. Democratic Senators from coal states have been as reluctant as Republicans to move this forward, and it’s largely stalled. Further, the failure of the recent Copenhagen Summit to produce anything meaningful also dooms this bill’s speedy passage in the Senate. Scott Brown—strike three—it’s out. Tax tinkering raises uncertainty in the short term. But we expect Congress will reinstate the AMT patch (as they traditionally have). The Republicans may stall on the AMT patch (traditionally a Blue-state concern) to get some concessions on the expiring Bush tax cuts. Everyone likes lower taxes, but counter to intuition, history shows surprisingly little meaningful correlation between stock prices and tax policy changes. Congress is almost certainly going to re-implement an estate tax. The details are uncertain, such as if it will be retroactive to January 1 and what the future tax rate and exemption level will be, but the likelihood of a permanent expiration of the estate tax approaches zero. Unemployment has some politicians backing a second stimulus but it is unlikely to pass. The House did pass a $174 billion “jobs bill” in December, but ratcheted government spending during the recession should make a second stimulus less politically feasible, particularly in an election year. Should it pass, however, there’s little cause for fear as the US total debt, though elevated, isn’t near worrisome levels. “Cap and Trade” AMT patch, estate tax, and expiring capital gains tax cuts The “Second Stimulus” A Global Shift? Because the US voted more heavily Democrat in 2008, there’s a sense the world has shifted left in response to the global financial crisis. However, taken together, the globe’s political balance has seen no net change, and may have even shifted slightly to the center-right. 24 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. Japan did indeed shift left, booting the long entrenched right-leaning Liberal Democratic Party (LDP) in favor of the decidedly more leftist Democratic Party of Japan (DPJ) last summer. But we find many more examples of the opposite move. Left-leaning Gordon Brown and his Labour Party lost support in the UK, and the center-right Tories appear poised to take office in the mid-2010 general election. Center-right German Chancellor Angela Merkel not only secured reelection in September 2009, but gained enough support to replace the leftist portion of her previous coalition with the right-wing Free Democratic Party (FDP). Europe as a whole followed suit as the EU parliament moved heavily to the center-right in June 2009’s EU-wide elections. Canada’s conservative Tory Party gained parliamentary seats in October’s 2008 election and has opened a roughly 10% lead over the Liberal Party at the polls. Australia’s new opposition leader is more conservative and has been polling better than his predecessor tied to his opposition to cap-and-trade. Of the major developing countries, Indian voters reelected their right-leaning prime minister, Manmohan Singh, and his party the United Progressive Alliance to a much stronger than expected victory. Brazil’s Lula will be replaced as his term ends later this year. He’s a liberal in name, but has functioned largely as a free-market conservative. Which way his replacement swings remains to be seen. In addition to elections this year (the US, the UK, Japan and Brazil) Exhibit 17 (following page) details a sampling of other major political events we’re monitoring in 2010 and our view of them. Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 25 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Exhibit 17: Global Legislative and Regulatory Action Global Legislative and Regulatory Action Carbon taxes Likely Market Impact A cap and trade bill is stalled in the US, the Copenhagen Summit failed to produce anything, and a lingering “climate-gate” scandal signals enthusiasm for new carbon taxes—which are effectively a tax on business—are on the wane. Already, Australia has abandoned its cap-and-trade scheme. This one likely goes nowhere soon and therefore won’t affect markets much. The US and China introduced retaliatory tariffs in 2009 on a small number of items. Despite that, global trade overall became more free in 2009 with a number of new free trade pacts being inked. Notably, a new pact was agreed to by perennial foes, China and Taiwan. Global trade likely continues becoming more open in 2010 despite heightened protectionist rhetoric that follows most recessions, but if we are wrong, this could dampen our more optimistic market expectations. The Basel Committee on Banking Supervision is considering more stringent financial guidelines— including requiring banks to keep more capital on hand and limit leverage. The new guidelines are subject to scrutiny and public comment until April. The guidelines are currently fairly stringent— adoption in their current form would represent just one of the headwinds Financials face—but shouldn’t hold up recovery overall. Global trade New Basel guidelines 26 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 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 23 developed countries and is presented net of withholding taxes and uses a US tax basis. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets. i ii iii iv v vi vii viii ix x xi xii xiii xiv xv xvi xvii xviii xix xx xxi Thomson Reuters; Fisher Investments Thomson Reuters; Fisher Investments Thomson Reuters Thomson Reuters Thomson Reuters, price level returns Global Financial Data, Inc. Thomson Reuters; Bloomberg Finance L.P.; Global Financial Data, Inc. Global Financial Data, Inc. Global Financial Data, Inc.; Thomson Reuters Global Financial Data, Inc.; Thomson Reuters Thomson Reuters US Bureau of Economic Analysis; Thomson Reuters; Q3 2008 through Q3 2009 Thomson Reuters, as of 09/30/2009 Thomson One Analytics Congressional Budget Office Thomson Reuters; US Bureau of Economic Analysis; Federal Reserve; Fisher Investments Federal Reserve Flow of Funds, Q3 2009 FDIC US Bureau of Economic Analysis; Fisher Investments US Bureau of Economic Analysis; Thomson Reuters US Bureau of Economic Analysis; Thomson Reuters Past performance is no guarantee of future results. A risk of loss is involved with investing in stock markets. Copyright ©2010 Fisher Investments. All rights reserved. Confidential. For personal use only. 27 Phone: (800) 568-5082 Email: [email protected] Website: www.fisherinvestments.com ...
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This note was uploaded on 04/20/2010 for the course TEAM RH131 taught by Professor Jesse during the Spring '10 term at Rose-Hulman.

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