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Alaska Senate Finance Committee Market & Economic Review 2009 Capital Market Projections APFC Performance February 2009 Michael J. O’Leary CFA Executive Vice President Prepared 2-03-09 Callan Associates Knowledge for Investors Fourth quarter overview Terrible market environment for all major asset classes Credit markets froze around the world Extraordinary governmental policy actions initiated quickly but not as rapidly as many had hoped Flight to quality resulted in sharp declines in short-term government rates and increases in “risk” premiums. Commodity prices fell sharply as expectations regarding the length and depth of economic slowdown mounted U.S. dollar strengthened significantly hurting profits for multinationals, unhedged international investors and returns on international investments for U.S. based investors. 2009 Capital Market Projections Callan Associates Knowledge for Investors 1 Second Half of 2008: Startling Period Fannie Mae and Freddie Mac placed into conservatorship. Washington Mutual seized by regulators, assets sold to JP Morgan. Lehman Brothers declared bankruptcy. AIG rescued by government. Merrill Lynch sold to Bank of America. Morgan Stanley and Goldman Sachs convert to bank holding companies, voluntarily placing themselves under the regulatory oversight of the Fed. $750 billion rescue plan passed. Money market funds “break the buck” for the first time. Oil drops by $100/barrel, commodity prices cool. Wachovia bought by Wells Fargo. U.S. and other sovereign governments make direct investments in banks. Nowhere to hide - virtually all asset classes except nominal Treasury bonds suffer steep declines. Housing market remains locked in a death spiral. Global economies follow the U.S. into deep recession. Timeline from Principal Global Investors 2009 Capital Market Projections Callan Associates Knowledge for Investors 2 U.S. Fixed Income 2009 Capital Market Projections Callan Associates Knowledge for Investors 3 The Capital Markets What a Difference One Year Can Make Average Annual Return Five Years Five Years Ten Years Ten Years Fifteen Years Fifteen Years 2003-07 2004-08 1998-07 1999-08 1993-07 1994-08 2003 2004 2005 2006 2007 2008 Broad U.S. Stock Market Russell 3000 S&P Super Composite 1500 31.06 29.59 11.95 11.78 6.12 5.66 15.72 15.34 5.14 5.47 -37.31 -36.72 13.63 13.23 -1.95 -1.89 6.22 6.35 -0.80 -0.76 10.49 10.66 6.36 6.59 Large Cap U.S. Stocks Russell 1000 S&P 500 29.89 28.80 11.40 10.88 6.27 4.91 15.46 15.79 5.77 5.49 -37.60 -37.00 13.43 12.83 -2.04 -2.19 6.20 5.91 -1.09 -1.38 10.58 10.49 6.47 6.46 Small Cap U.S. Stocks Russell 2000 S&P 600 Small Cap 47.25 38.79 18.33 22.65 4.55 7.68 18.37 15.11 -1.57 -0.30 -33.79 -31.07 16.25 16.04 -0.93 0.88 7.08 9.03 3.02 5.18 10.10 11.78 5.89 7.80 Non-U.S. Stock Markets EAFE ($US) MSCI Emerging Markets 38.59 56.28 20.25 25.95 13.54 34.54 26.34 32.59 11.17 39.78 -43.38 -53.18 21.59 37.46 1.66 8.02 8.66 14.53 0.80 9.31 9.56 12.16 3.52 2.73 Fixed Income Markets LB Aggregate Citi Non-US Bonds 4.10 18.52 4.33 12.14 2.43 -9.21 4.33 6.95 6.97 11.45 5.24 10.11 4.42 7.54 4.65 5.97 5.97 6.30 5.63 5.59 6.47 6.79 6.18 6.47 Cash Market 90-day T-bill 1.15 1.33 3.07 4.85 5 2.06 3.07 3.25 3.77 3.45 4.09 4.02 Inflation CPI-U* 1.88 3.26 3.42 2.54 4.08 0.09 3.03 2.67 2.67 2.51 2.64 2.47 * Annual CPI-U data are measured as year-over-year change. Results for 2008 substantially reduce equity returns across all periods. Five-year returns through 2007 were very robust for equity, now they are negative. Ten-year results are weak as the tech bubble years continue roll out of the calculations. Fifteen-year results are now weak, and roughly on par with those of fixed income. 2009 Capital Market Projections Callan Associates Knowledge for Investors 4 Real Estate NCREIF Returns 8% 6% 4% Return 2% 0% -2% -4% Total Return -6% Income Return -8% Capital Return -10% 2009 Capital Market Projections 2005 2006 2007 2008 2001 2002 2003 2004 1997 1998 1999 2000 1993 1994 1995 1996 1990 1991 1992 1986 1987 1988 1989 1982 1983 1984 1985 1978 1979 1980 1981 -12% Callan Associates Knowledge for Investors 5 The Capital Markets What a Difference One Year Can Make Average Annual Return Five Years Five Years Ten Years Ten Years Fifteen Years Fifteen Years 2003-07 2004-08 1998-07 1999-08 1993-07 1994-08 2003 2004 2005 2006 2007 2008 Broad U.S. Stock Market Russell 3000 S&P Super Composite 1500 31.06 29.59 11.95 11.78 6.12 5.66 15.72 15.34 5.14 5.47 -37.31 -36.72 13.63 13.23 -1.95 -1.89 6.22 6.35 -0.80 -0.76 10.49 10.66 6.36 6.59 Large Cap U.S. Stocks Russell 1000 S&P 500 29.89 28.80 11.40 10.88 6.27 4.91 15.46 15.79 5.77 5.49 -37.60 -37.00 13.43 12.83 -2.04 -2.19 6.20 5.91 -1.09 -1.38 10.58 10.49 6.47 6.46 Small Cap U.S. Stocks Russell 2000 S&P 600 Small Cap 47.25 38.79 18.33 22.65 4.55 7.68 18.37 15.11 -1.57 -0.30 -33.79 -31.07 16.25 16.04 -0.93 0.88 7.08 9.03 3.02 5.18 10.10 11.78 5.89 7.80 Non-U.S. Stock Markets EAFE ($US) MSCI Emerging Markets 38.59 56.28 20.25 25.95 13.54 34.54 26.34 32.59 11.17 39.78 -43.38 -53.18 21.59 37.46 1.66 8.02 8.66 14.53 0.80 9.31 9.56 12.16 3.52 2.73 Fixed Income Markets LB Aggregate Citi Non-US Bonds 4.10 18.52 4.33 12.14 2.43 -9.21 4.33 6.95 6.97 11.45 5.24 10.11 4.42 7.54 4.65 5.97 5.97 6.30 5.63 5.59 6.47 6.79 6.18 6.47 Cash Market 90-day T-bill 1.15 1.33 3.07 4.85 5 2.06 3.07 3.25 3.77 3.45 4.09 4.02 Inflation CPI-U* 1.88 3.26 3.42 2.54 4.08 0.09 3.03 2.67 2.67 2.51 2.64 2.47 * Annual CPI-U data are measured as year-over-year change. Results for 2008 substantially reduce equity returns across all periods. Five-year returns through 2007 were very robust for equity, now they are negative. Ten-year results are weak as the tech bubble years continue roll out of the calculations. Fifteen-year results are now weak, and roughly on par with those of fixed income. 2009 Capital Market Projections Callan Associates Knowledge for Investors 6 Second Half of 2008: Startling Period Fannie Mae and Freddie Mac placed into conservatorship. Washington Mutual seized by regulators, assets sold to JP Morgan. Lehman Brothers declared bankruptcy. AIG rescued by government. Merrill Lynch sold to Bank of America. Morgan Stanley and Goldman Sachs convert to bank holding companies, voluntarily placing themselves under the regulatory oversight of the Fed. $750 billion rescue plan passed. Money market funds “break the buck” for the first time. Oil drops by $100/barrel, commodity prices cool. Wachovia bought by Wells Fargo. U.S. and other sovereign governments make direct investments in banks. Nowhere to hide - virtually all asset classes except nominal Treasury bonds suffer steep declines. Housing market remains locked in a death spiral. Global economies follow the U.S. into deep recession. Timeline from Principal Global Investors 2009 Capital Market Projections Callan Associates Knowledge for Investors 7 APFC Calendar Period Performance Returns for Calendar Years 8 Years Ended December 31, 2008 Group: CAI Public Fund Sponsor Database 40.0 20.0 A (60) A (62) A (36) A (41) A (29) 0.0 A (27) A (21) (20.0) A (55) (40.0) 10th Percentile 25th Percentile Median 75th Percentile 90th Percentile APFC A 2008 2007 2006 2005 2004 2003 2002 2001 (19.84) (22.66) (25.27) (27.14) (29.71) 10.87 9.57 8.20 6.86 6.15 15.76 15.05 14.04 12.29 10.37 9.34 8.61 7.54 5.86 4.23 13.13 12.31 11.47 10.17 8.26 26.12 23.99 21.14 19.68 14.55 (3.07) (5.96) (8.26) (9.52) (11.46) 0.20 (1.79) (3.46) (5.38) (6.67) (25.70) 8.90 13.63 8.46 11.83 20.59 (5.39) (1.85) Please note returns are preliminary. Background data for other public funds may be distorted owing to valuation policies regarding illiquid investments. APFC returns include current estimates for real estate (with 1 exception). Many others lag such returns by ¼ year. 2009 Capital Market Projections Callan Associates Knowledge for Investors 8 Stock Market Returns by Calendar Year 2008 Performance in Perspective - History of the U.S. Stock Market 218 Years of Returns 2008 return = negative 37.0% 1931 1807 -50% 2009 Capital Market Projections 2008 1937 1801 -40% 2002 1974 1930 1917 1907 1857 1854 -30% Callan Associates, Inc. 2001 1973 1957 1926 1920 1903 1893 1884 1876 1858 1842 1841 1839 1836 1810 -20% 2000 1990 1981 1977 1969 1966 1962 1946 1941 1940 1932 1914 1913 1910 1890 1887 1883 1877 1873 1869 1859 1853 1838 1837 1831 1828 1825 1819 1812 1811 1797 1796 1795 1792 -10% 2007 2005 1994 1992 1987 1984 1978 1970 1960 1956 1953 1948 1947 1939 1934 1929 1923 1916 1912 1911 1906 1902 1896 1895 1894 1892 1889 1888 1882 1881 1875 1874 1870 1867 1866 1864 1851 1849 1848 1847 1846 1833 1827 1826 1822 1816 1815 1805 0% 2006 2004 1993 1988 1986 1972 1971 1968 1965 1964 1959 1952 1942 1921 1909 1905 1900 1899 1891 1886 1878 1872 1871 1868 1865 1861 1855 1845 1844 1840 1835 1829 1824 1823 1821 1820 1818 1813 1806 1803 1802 1793 1791 10% 2003 1999 1998 1996 1983 1982 1979 1976 1967 1963 1961 1955 1951 1950 1949 1944 1943 1938 1925 1924 1922 1919 1918 1901 1898 1897 1885 1880 1860 1856 1834 1830 1817 1809 1800 1799 1798 1794 1790 20% 1997 1995 1991 1989 1985 1980 1975 1945 1936 1928 1927 1915 1904 1852 1850 1832 30% 1958 1935 1908 1879 1863 40% 1954 1933 1862 1808 1804 50% 1843 1814 60% 70% 80% Callan Associates Knowledge for Investors Source: Ibotson, Roger G., Investment Markets (Updated) 9 2009 Capital Market Projections 12/08 12/06 12/04 12/02 12/00 12/98 12/96 12/94 12/92 12/90 12/88 12/86 12/84 12/82 12/80 12/78 12/76 12/74 12/72 12/70 12/68 12/66 12/64 12/62 12/60 12/58 12/56 -10% 12/54 12/52 12/50 12/48 12/46 12/44 12/42 12/40 12/38 12/36 12/34 12/32 12/30 Rolling Annualized Return (%) Rolling 5-Year Geometric Returns Rolling 5 Year Returns for S&P 500 (1926 to 2008) 40% 30% 20% 10% 10.35% 5.78% 0% -2.19% Actual Average Smoothed -20% Callan Associates Knowledge for Investors 10 Credit Spreads Exceed Historic Highs Investment Credit Spreads over Treasury Instruments 2009 Capital Market Projections Callan Associates Knowledge for Investors 11 Potential Implications of Financial Crisis Structure of U.S. financial system is changed permanently. – – – – – End of traditional investment banks. Consolidation of financial institutions into large, highly regulated commercial banks. More government oversight and regulation. Lower leverage and ultimately lower risk in financial system. Tighter credit conditions for foreseeable future. U.S deficit and overall federal debt will expand dramatically. – – – Trillion dollar plus deficits likely in near term. Risk of devaluation of U.S. dollar elevated. Long-term risk of higher real interest rates and crowding out of private borrowing. U.S. consumer is being forced to delever. – – – Loss of wealth in housing and equities will change behavior. Less spending and consumption. Postponed retirements, second jobs, will expand labor force. Financial markets become smaller and less efficient. – – – Fewer market makers with smaller balance sheets. Derivative markets shrink due to increased regulation and tighter risk controls. Lower leverage from Wall Street firms suggests lower profitability and lower compensation, pushing human capital away from finance into other areas. 2009 Capital Market Projections Callan Associates Knowledge for Investors 12 U.S. Economic Growth by Sector (Annual percent change) Real GDP Consumption Residential Investment Bus. Fixed Investment Federal Government State & Local Govt. Exports Imports 2007 Share of GDP 100% 72% 4% 12% 7% 11% 12% 17% 2002 1.6 2.7 4.8 -9.2 7.0 3.1 -2.3 3.4 2003 2.5 2.8 8.4 1.0 6.8 0.2 1.3 4.1 2004 3.6 3.6 10.0 5.8 4.2 -0.2 9.7 11.3 2005 2.9 3.0 6.3 7.2 1.2 -0.1 7.0 5.9 2006 2.8 3.0 -7.1 7.5 2.3 1.3 9.1 6.0 2007 2.0 2.8 -17.9 4.9 1.6 2.3 8.4 2.2 2008 1.2 0.3 -21.0 1.9 5.7 1.2 6.4 -3.1 Direction of Change Contracting now Contracting now Falling Sharply Surge halted abruptly Surging higher Tax revenue in jeopardy Reversing course Oil Prices Housing downturn reduced GDP growth by over 1.0% each year in 2007 and 2008 through direct effect on construction alone. Note: Imports are a negative number in the calculation of GDP. Source: Global Insight 2009 Capital Market Projections Callan Associates Knowledge for Investors 13 Hard Landing for the U.S. Economy *2009 estimate - Global Insight (Real GDP - annual percent change) 5 4 3 2 1 0 -1 -2 -3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: Global Insight 2009 Capital Market Projections Callan Associates Knowledge for Investors 14 The Current Economic Environment Worst Recession in the Post-War Era? Largest global housing and credit bubble in history has burst. Households, businesses and governments face tight (or no access to) credit and massive wealth destruction. The U.S. economy entered recession in December 2007. – Better than expected growth in the first half of 2008 was an illusion conjured by trade and the stimulus package. Housing has been in recession for three years, subtracting at least a percentage point from GDP growth in both 2007 and 2008. – Offset by strength in non-residential construction and the closing of the trade gap – each added back half a point of growth in 2007. – Housing market has another bad year in front of it. Consumer confidence is deep in recession territory. – Job market has turned sour, piling on to the woes from the housing and stock markets. Rest of the world is going into severe recession, undermining exports. Economy is in a free-fall right now – recession may be long and deep. Lower oil prices offer some cushion. Fed is doing all it can; major fiscal stimulus is coming. Sustained upturn may have to wait until the second half of 2009. 2009 Capital Market Projections Callan Associates Knowledge for Investors 15 The Current Economic Environment Slow going until 2010. Optimistic outlook: government intervention stabilizes credit markets, fiscal stimulus kick-starts rapid upswing. Beware of inflation lurking in the wings. Pessimistic scenario: vicious downward spiral between the economy and credit markets worsens. Specter of deflation looms. Most likely scenario: severest declines in GDP will be recorded in fourth quarter of 2008 and first quarter of 2009. GDP resumes modest growth in the second half of 2009, as credit markets slowly unthaw and confidence returns. Impact of policy will take time. – Monetary policy impact is famously “long and variable”. – Substantial fiscal policy has prospects for quicker success, but infrastructure spending will take years, not months, to show up. Policy is not cheap: fiscal 2008 deficit beat the 2004 record; 2009 deficit will more than double. Economy will feel like it is in recession well into 2010, when unemployment will peak, potentially reaching 10%. Equity markets tend to begin recovering before recession ends. Experience after major bear markets since WWII suggests strong performance in the subsequent period. 2009 Capital Market Projections Callan Associates Knowledge for Investors 16 The Current Economic Environment Slow going until 2010. The Fed cut rates 500 basis points in response to the financial turmoil that began unfolding in 2007. – The Federal Funds Rate is now down to 0.25%. – The Fed is focused on stabilizing the financial system and kick-starting the economy. Deflation is a real problem once again; future inflationary pressures of Fed and Treasury actions are less of a concern. Callan’s outlook: – Inflation will be contained and low interest rates will persist. – Historic nominal return averages may be hard to achieve over the long run, but... – Stocks will likely lead the economic recovery, and could generate above-trend results coming off the bottom. The timing is unclear. – Solvency rather than liquidity is the real problem that must be worked through in the capital markets – liquidity is emotion, solvency is hard numbers. – The dollar will likely remain down as the Fed focuses on fighting a recession, but U.S. Treasuries will continue to be valued as the safest store of value in a time of uncertainty. Biggest challenge facing investors – determining when we might hit bottom in the slowdown, and how the capital markets will respond. 2009 Capital Market Projections Callan Associates Knowledge for Investors 17 Equity Is More Reasonably Priced Trailing P/E Dips Below Its Long Run Average Price to Earnings Ratio for S&P 500 (1954 - 2008) 45 S&P 500 P/E Ratio Price/Earnings Ratio 40 Long-Run Average 35 + 2 Std. Dev. 30 25 20 15 10 - 2 Std. Dev. 5 2004 1999 1994 1989 1984 1979 1974 1969 1964 1959 1954 0 Trailing earnings as reported for the fiscal year; includes negative earnings from 1998 onward. 2009 Capital Market Projections Callan Associates Knowledge for Investors 18 Past Recessions and Subsequent Market Performance Reproduced from JP Morgan Guide to the Markets, December 31, 2008. 2009 Capital Market Projections Callan Associates Knowledge for Investors 19 Current Yield is Exceptionally Low Aggregate Masks Substantial Divergence in Sector Yields Lehman Aggregate Index - Daily Yield to Worst from 1/1/01 to 1/16/09 6.75% 6.50% 6.25% 12/31/2001 6.00% 03/25/2002 06/28/2006 5.75% 06/12/2007 12/29/2006 10/31/2008 09/10/2001 5.50% Yield to Maturity 11/04/2005 5.25% 03/28/2005 06/14/2004 5.00% 12/05/2006 11/07/2001 4.75% 09/03/2003 12/30/2005 12/31/2007 4.50% 4.25% 01/23/2008 4.00% 12/31/2004 12/31/2002 3.75% 12/31/2003 3.75% 3.99% 12/31/08 03/16/2004 3.50% 01/08/2009 3.25% 06/13/2003 2009 Capital Market Projections 12/02/2008 09/04/2008 06/10/2008 03/14/2008 12/17/2007 09/19/2007 06/25/2007 03/29/2007 01/02/2007 10/04/2006 07/11/2006 04/13/2006 01/18/2006 10/19/2005 07/25/2005 04/28/2005 02/01/2005 11/03/2004 08/09/2004 05/13/2004 02/18/2004 11/19/2003 08/22/2003 05/29/2003 03/04/2003 12/05/2002 09/09/2002 06/13/2002 03/20/2002 12/20/2001 09/24/2001 06/25/2001 03/29/2001 01/02/2001 3.00% Callan Associates Knowledge for Investors 20 2009 Capital Market Projections Domestic Fixed Callan Associates Knowledge for Investors 2008 2007 2006 Price Return 2005 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 Total Return 2004 2003 2002 -15.00 2001 -15.00 2000 -10.00 1999 -10.00 1998 -5.00 1997 -5.00 1996 0.00 1995 0.00 1994 5.00 1993 5.00 1992 15.00 1991 15.00 1990 20.00 1989 20.00 1988 25.00 1987 25.00 1986 30.00 1985 30.00 1984 35.00 1982 -15.00 1983 -10.00 1981 -5.00 1982 0.00 1980 5.00 1981 15.00 1979 15.00 1980 20.00 1978 20.00 1979 25.00 1977 25.00 1978 1976 10.00 Return (%) 30.00 1977 10.00 Return (%) 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 Return (%) 30.00 1976 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 Return (%) 35.00 BC Aggregate Index - Annual Return Breakdown 35.00 Coupon Return 10.00 5.00 0.00 -5.00 -10.00 -15.00 35.00 Other Return (Paydown) 10.00 Source: www.lehmanlive.com. 21 Does the Treasury Yield Curve Relate to Broad Market Opportunities? U.S. Treasury Yield Curves 5.5 5.02 (Source: Federal Reserve Constant Maturity, 3mo/1yr/2yr//5yr/10yr/20yr/30yr) 4.70 5.0 4.81 4.71 4.5 Yield (%) 4.0 4.04 3.36 4.45 3.5 3.45 3.0 2.5 12/31/2004 12/31/2005 12/31/2006 12/31/2007 12/31/2008 2.0 1.5 1.0 0.5 0.0 1 21 11 31 Maturity (Years) 2009 Capital Market Projections Callan Associates Knowledge for Investors 22 Bond Market Opportunities We don’t know when markets will react positively to the extraordinary governmental policy actions taken to restore liquidity to credit markets, but we are confident that they will. We believe that risk spreads (both credit and equity) have reached very attractive levels and patient investors will be handsomely rewarded from recent price levels. We do not expect credit spreads to return to the slim premiums of 2004 to early 2007. The extraordinarily low yield and duration on the Aggregate mask the extreme divergence between the component sectors of the index, and therefore the potential opportunities. Very large increase in specialized “distress” oriented fixed investing. 2009 Capital Market Projections Callan Associates Knowledge for Investors 23 2009 Capital Market Expectations Major question - Did we go through a “game-changing” experience, or a somewhat extreme but within-the-bounds-ofexpected bump in the long-term capital markets road? All asset classes repriced in the recent market dislocation. Value opportunities are emerging throughout the capital markets. General theme: this revaluation suggests better potential returns going forward, and a steeper capital market line. We held our inflation expectation at 2.75%. Inflation topped 5% in mid-2008 yet finished the year with a decline. A recession solved our inflation problem over the short term, and the reversal in oil prices played a large role. Inflation could easily resume, especially given the massive monetary and fiscal stimulus in the pipeline. Cash is projected to generate a slight positive real return (3.0%). We do not expect current low rates to persist over a five- to tenyear time horizon. 2009 Capital Market Projections Callan Associates Knowledge for Investors 24 2009 Capital Market Expectations Bond returns held at 5.25%. Current measures of the broad market are very unusual. We expect Treasury rates to rise, but spreads will narrow and opportunities abound in the non-Treasury portion of the market. Project an upward sloping yield curve, with a risk premium for bonds over cash (2.25%). Building equity returns from long-term fundamentals gets us to about 9%: 3-4% real GDP growth, which means 5.75%-6.75% nominal earnings growth, 2% dividend yield, 0.5%-1.0% “buyback yield”. Shorter term, these fundamentals may look weak, but equity looks cheap relative to longer-term valuations. Equity markets tend to perform well after substantial declines, and typically lead the economy out of recession. Broad U.S. equity expectations are increased 50 bps, from 9.0% to 9.5%. Non-U.S. equity returns are increased by a similar amount. Real estate return held at 7.6%; returns may not recover as quickly as liquid equity markets. Private equity return held at 12%, narrowing its premium over public equity markets. 2009 Capital Market Projections Callan Associates Knowledge for Investors 25 NACUBO Study – Data as of 6/30/08 How are others with similar objectives invested? Average Asset Class Allocation of Total Assets Greater Than $1 Billion > $500 Million to ? $1 Billion > $100 Million to ? $500 Million > $50 Million to ? $100 Million > $25 Million to ? $50 Million Less Than or Equal to $25 Million % 39.4 42.5 50.4 54.1 57.6 55.9 Fixed Income % 10.8 14.6 16.5 20.3 20.8 27.1 Public Private 51.7 52.0 21.4 18.1 3.5 4.4 4.8 3.4 11.0 13.8 2.9 3.5 0.8 1.2 2.4 2.2 1.6 1.5 Equal-weighted Average Dollar-weighted Average 51.9 40.0 19.2 13.1 4.1 6.5 3.9 0.5 12.9 21.0 3.3 8.4 1.1 3.2 2.2 6.5 1.5 0.9 Investment Pool Assets Equity Real Estate % 6.4 6.1 4.1 4.2 4.1 2.2 % 1.4 1.9 2.5 4.4 3.4 8.1 Hedge Funds % 22.6 19.2 16.4 11.5 10.4 3.3 Private Equity % 10.0 7.7 4.3 1.8 1.0 0.6 Venture Capital % 3.6 2.8 1.2 0.5 0.3 0.3 Natural Resources % 5.3 3.5 3.0 .19 1.2 0.4 Cash Other % 0.5 1.7 1.7 1.4 1.1 2.1 774 institutions provided investment pool asset class data in 2008. Table data are equal weighted unless otherwise noted. Natural resources include: Timber, Oil and Gas Partnerships, and Commodities. 2009 Capital Market Projections Callan Associates Knowledge for Investors 26 2009 Capital Market Expectations Return and Risk Asset Class Broad Domestic Equity Large Cap Small/Mid Cap International Equity Emerging Markets Equity Global Domestic Fixed Non US Fixed Real Estate/Infrastructure Private Equity Absolute Return Cash Equivalents 5-Year 10-Year Arithmetic Geometric Geometric Projected Mean Mean Mean S.D. 10.35 9.63 9.49 16.39 9.95 9.36 9.23 15.25 11.95 10.33 10.05 22.60 10.60 9.47 9.26 19.30 13.00 10.54 10.13 27.00 10.28 9.63 9.49 15.85 5.25 5.25 5.24 5.00 5.15 4.88 4.83 9.60 8.55 7.75 7.61 16.10 17.25 12.38 11.59 37.00 7.20 6.99 6.93 10.00 3.00 3.03 3.03 0.80 Source: Callan Associates Inc. 2009 Capital Market Projections Callan Associates Knowledge for Investors 27 2009 Capital Market Expectations Correlation Coefficient Matrix Key to Constructing Efficient Portfolios Broad Domestic Equity Broad Domestic Equity 1.00 Large Cap 0.98 Small/Mid Cap 0.94 International Equity 0.68 Emerging Markets Equity 0.79 Global 0.89 Domestic Fixed 0.15 Non US Fixed -0.04 Real Estate/Infrastructure 0.54 Private Equity 0.92 Absolute Return 0.56 Cash Equivalents -0.12 Large Cap 0.98 1.00 0.90 0.68 0.79 0.89 0.17 -0.02 0.54 0.91 0.56 -0.10 Small/ Mid Cap 0.94 0.90 1.00 0.64 0.74 0.82 0.07 -0.06 0.51 0.87 0.51 -0.15 Interna- Emerging tional Markets Domestic Non US Equity Equity Global Fixed Fixed 0.68 0.79 0.89 0.15 -0.04 0.68 0.79 0.89 0.17 -0.02 0.64 0.74 0.82 0.07 -0.06 1.00 0.75 0.94 0.14 0.18 0.75 1.00 0.84 0.05 0.05 0.94 0.84 1.00 0.17 0.10 0.14 0.05 0.17 1.00 0.43 0.18 0.05 0.10 0.43 1.00 0.51 0.53 0.57 0.15 0.05 0.85 0.85 0.96 -0.02 0.02 0.60 0.53 0.63 0.41 0.24 -0.20 -0.15 -0.17 0.30 0.10 Real Estate/ Infra 0.54 0.54 0.51 0.51 0.53 0.57 0.15 0.05 1.00 0.55 0.43 -0.06 Private Absolute Equity Return 0.92 0.56 0.91 0.56 0.87 0.51 0.85 0.60 0.85 0.53 0.96 0.63 -0.02 0.41 0.02 0.24 0.55 0.43 1.00 0.54 0.54 1.00 -0.10 0.15 Cash Equivalents -0.12 -0.10 -0.15 -0.20 -0.15 -0.17 0.30 0.10 -0.06 -0.10 0.15 1.00 Source: Callan Associates Inc. 2009 Capital Market Projections Callan Associates Knowledge for Investors 28 Illustrative Efficient Mixes Using 2009 Projections Portfolio Component Large Cap Small/Mid Cap International Equity Global Emerging Markets Equity Domestic Fixed Non US Fixed Real Estate/Infrastructure Private Equity Absolute Return Cash Equivalents Totals Target 21 5 8 14 5 19 3 13 6 6 0 100 Expected Return 5 Yr. Avg. Simulated Return 10 Yr. Avg. Simulated Return Standard Deviation 9.35 9.00 8.91 12.82 2009 Capital Market Projections Min 0 0 0 0 0 0 0 0 0 0 0 Max 100 100 100 100 100 100 100 100 100 100 100 Mix 1 15 4 3 6 1 56 4 6 2 3 0 100 Mix 2 17 5 4 8 2 47 3 7 3 4 0 100 Mix 3 20 6 5 10 3 38 2 7 4 5 0 100 Mix 4 23 7 6 12 3 28 1 8 6 6 0 100 Mix 5 26 8 7 14 4 18 0 9 7 7 0 100 Mix 6 29 9 9 17 4 5 0 10 8 9 0 100 7.27 7.25 7.22 7.30 7.83 7.75 7.71 8.65 8.41 8.25 8.19 10.17 9.02 8.75 8.67 11.85 9.68 9.25 9.15 13.72 10.38 9.75 9.62 15.75 Callan Associates Knowledge for Investors 29 Efficient Frontier Graph 10.0 Mix 6 5-Year Geometric Mean Return (%) 9.5 Target Mix Mix 5 9.0 Mix 4 8.5 Mix 3 8.0 Mix 2 7.5 Mix 1 7.0 7 8 9 10 11 12 13 14 15 16 17 Risk (Standard Deviation) 2009 Capital Market Projections Callan Associates Knowledge for Investors 30 Supplemental Material 2009 Capital Market Projections Callan Associates Knowledge for Investors 31 Housing Information 2009 Capital Market Projections Callan Associates Knowledge for Investors 32 Home Prices 2009 Capital Market Projections Callan Associates Knowledge for Investors 33 Consumer Balance Sheet 2009 Capital Market Projections Callan Associates Knowledge for Investors 34 Unemployment & Employment Trends 2009 Capital Market Projections Callan Associates Knowledge for Investors 35 Consumer Sentiment 2009 Capital Market Projections Callan Associates Knowledge for Investors 36 Oil Prices & Impact 2009 Capital Market Projections Callan Associates Knowledge for Investors 37 S&P 500 2008 2009 Capital Market Projections Callan Associates Knowledge for Investors 38 Performance during recessions 2009 Capital Market Projections Callan Associates Knowledge for Investors 39 Ted Spread – Huge Improvement From Sept – Nov. 2009 Capital Market Projections Callan Associates Knowledge for Investors 40 Long-term High Yield Default Experience Graph reproduced from Principal Global Investors Jan. 2009 2009 Capital Market Projections Callan Associates Knowledge for Investors 41 Tax Exempt Yields vs. Treasury 2009 Capital Market Projections Callan Associates Knowledge for Investors 42 Market Background 2009 Capital Market Projections Callan Associates Knowledge for Investors 43 Projections from others - GMO GMO 7-Year Asset Class Return Forecasts* - Expected Value Added - Real Return (Asset Class Index) As of December 31, 2008 Stocks Bonds Other 16% 6.5 % Long-term Historical U.S. Equity Return 14% 1.8% Annual Real Return Over 7 Years 12% 10% 8% 13.8% 13.0% 13.6% 2.3% 11.1% 3.7% 2.3% 8.9% 8.6% 1.8% 1.8% 7.5% 6.8% 1.5% 6% 11.5% 11.2% 2.9% 9.9% 8.8% 4% 7.1% 2.9% 6.8% 2% 3.9% 0.4% 0.9%4 -0.5% 0% 0.9% 4 2.0% -0.2% 6.0% 1.6% 2 1.4% 0.2% -1.1% 0.9% -2% U.S. U.S. U.S. High Int'l. Int'l. Equities U.S. Bonds Int'l. Bonds Bonds equities equities Quality equities equities (emerging) (gov't.) (gov't.) (emerging) (large cap) (small cap) (large cap)3 (small cap)3 Estimated Range of 7-Year Annualized Returns ±6.5 ±7.0 ±6.0 ±6.5 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 Bonds (inflation indexed) ±1.5 U.S. Managed treasury Timber (30 days to 2 yrs.) ±1.5 ±5.5 forecasts 1 *The chart represents real return for several asset classes and an estimate of value expected to be added from active management. These forecasts are forwardlooking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. 1 2 Long-term inflation assumption: 2.5% per year. Alpha transported from management of global equities. 2009 Capital Market Projections 3 4 Return forecasts for international equities are ex-Japan. Alpha transported from management of global bonds. Source: GMO Callan Associates Knowledge for Investors 44 JP Morgan Asset Class Projections Source JP Morgan 11/30/08 2009 Capital Market Projections Callan Associates Knowledge for Investors 45 Year-end Strategists Projections 2009 Capital Market Projections Callan Associates Knowledge for Investors 46