QUARTERLY

Commentary
First QUARTER 2009

ECONOMICS

Bailout-Version 2.0
Bailout! The markets abhor uncertainty. We were reminded of this in spades when our new Secretary of the Treasury, Timothy Geithner, first spoke about the bailout package on February 10th. From that day to March 10 the Dow Jones fell about 2,000 points, or 21.6%. When we finally got some details about the plan on March 23rd, the market responded with a 500 point (6.8%) rise and has since climbed back to 7,609. Will the plan work? Yes. Is it the best plan? No. It is the most politically expedient plan that will quickly help turn the economy around. However, it will come at a large future cost. Essentially, the Obama Administration, Congress and the Federal Reserve have concluded that the easiest way to solve the crisis is to reignite inflation. This will eventually cause home prices to rise and thus allow homeowners who are under water to pay off their mortgages. The banks that hold these mortgages and the investors who bought the bonds backed by these mortgages will get paid and the loans and mortgagebacked-securities (MBS) will rise in price. Mr. Geithners plan, the PPIP (Public-Private Investment Program) is a deal that Wall Street cannot pass up. Some of the details are as follows: 15% down. The Fed will provide qualified private investors with cheap government financing. These investors will buy up the toxic mortgages and MBS that are at the heart of the crisis. The private investors will get to keep 50% of the profit and the Government will keep the rest. Who is likely to be deemed qualified? It will be the largest financial firms which have a cadre of staff experienced in the mortgage securities business. But arent these the same folks who created all these securities and should have seriously known what a mess they were creating in the first place? As an example, a group of former Countrywide Financial executives has started a new firm that has been buying delinquent home mortgages that the government took over from failed banks at steep discounts to their original value. Though the thought of this new firm profiting from the very problem they helped to create is distasteful, it is this activity that will ultimately lead to stable pricing of these toxic securities.
INDEX PERFORMANCE Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Lehman Intermediate Lehman Municipal Q109 -12.48 -10.98 -13.95 -14.95 -0.04 4.21 YTD -12.48 -10.98 -13.95 -14.95 -0.04 4.21

Inside this Issue

ECONOMICS

: : Bailout-Version 2.0
ASSET MANAGEMENT

: : High Anxiety in the Equity Market

COMMENTARY

: : Are Bonds a Safe Haven?

WEALTH MANAGEMENT

: : The Case for Stocks and Against Market Timing

Once the toxic junk is off of the banks books, happy days will be here again, right? The answer is yes, at least for awhile. There are two risks to investing in mortgages. First is the risk of default, that is, will the borrower remain current with payments and be able to repay the loan when due? Default risk is the current problem and stimulus and bailout funds are focused on addressing this. The second risk is the prepayment risk. Will investors get their principal back when they expect it? When rates fall, borrowers re-finance their loans, if they can, and MBS investors get back their principal sooner than they want it. Conversely, when rates rise, borrowers postpone selling or refinancing and the MBS

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investors see prepayment speeds slow down. This causes MBS bond duration to extend and the market price of their bonds to fall. The longer the duration, the greater the resulting price decline will be in a rising interest rate (inflationary) market. (See the Commentary article on the bond market.) Our government is already in the process of massively expanding governmental borrowing and the money supply. It will take some time for the impact to be felt. Much of the money from the bailout is not yet in circulation as initial recipients have absorbed these funds to
Inflation Expectations
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(from 0.5% to over 1.0%). We expect this figure will be over 2.5% before year end. For most of this decade, 2.5% has been the average level of expected inflation. As a result of the governments increased borrowing and money supply, inflation expectations could easily move well beyond this average.

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During his campaign, President Obama promised a number of significant social programs. The most costly of these likely will be the universal healthcare initiative. How this might work and what it will cost is pure speculation at this point, but when the government decides to pay for services that were not previously March 31, 2008 - March 31, 2009 available, the result is usually inflationary. When 1 0 we add the impact of keeping these campaign 31 h3 t3 c p rc Se De Ma promises to the fiscal and monetary stimulus to date, we conclude that inflation will be an enormous problem in the next few years. As Margaret Thatcher once observed the problem with socialism is that you eventually run out of other peoples money. The only solution then would be to print more money, which would result in runaway inflation and a very weak dollar. We believe it unlikely that the Fed will be able to tighten fast enough to avoid a new era of inflation.
2009 Bloomberg Finance L. P.

bolster their balance sheets. Similarly, consumers are conserving funds now that the rainy day has arrived. Eventually, these increased savings will go back into circulation. When this happens the velocity of money goes up and magnifies the impact of the increased supply. When the supply of money rises, the demand for goods also rises and this increases the price of those goods. The markets are already beginning to anticipate this rising inflation (see chart) with 5 year inflation expectations doubling in the last two weeks of March

Despite our concerns, we have faith that the capital markets will moderate the actions of the government and the Fed. Over the longer term, businesses will adjust to the stimulus and the inflationary impact, just as they have during past bouts with inflation. Todays capital creation will create economic value and equity investors will be rewarded. Our efforts to research and invest in those businesses that will prosper the most in this environment are ongoing. The road will continue to be bumpy, however. In the meantime, we are enjoying the rally from the March 10th lows.

tors, a carefully selected equity

ASSET MANAGEMENT

High Anxiety in the Equity Market

The most basic explanation for the stock market decline is that more people are selling stocks than are buying them. There are many reasons for selling, but fundamentally, as Mark Twain once said: The cat, having sat on a hot stove lid, will not sit on a hot stove lid again. But he wont sit on a cold stove lid, either. For years, economists and government gurus have bemoaned the minuscule amount of money that most Americans were putting into savings. Now the savings rate has climbed dramatically to about 5%, as individuals have pulled money out of the stock market and put it into money market accounts or even tucked it under their mattresses. Companies are focusing on strengthening their balance sheets, which requires cash. This means that they are cutting dividends and decreasing stock buybacks. Optimists believe that people and institutions will soon tire of receiving virtually zero return on their money, but we are not so sure. There is very little appetite for risk right now. It may be a long, slow recovery from the shock most people have experienced as they have watched their assets decline. A few statistics from a recent Wall Street Journal article entitled Will Queasy Money Return?: Holdings in cash (money market funds) have increased from 43% to 84% of the value of the U.S. stock market. This is due to both cash increases and declines in the value of stocks. The historical average is 66%. As of December 2008, there was $3.8 trillion in money market accounts. Investors say their cash holdings are 30%, up from 23%. Investors are looking for lower-risk investments and the stock market certainly does not appear to fall into that category. In sum, equity investments are now a source of huge anxiety and most investors have either sold significant portions of their portfolios or are hunkered down trying to wait out the economic turmoil. As a result, people are paying little attention to company fundamentals (particularly companies in non-financial sectors) while a great deal of attention is centered on the latest government actions. We analyze our portfolio of stocks and candidates for addition to the Nelson Roberts portfolio based on a companys historic performance combined with our rationale for why future performance will exceed current market expectations. Outperformance could come as a result of improved internal efficiencies, growth in the industry, or market share gains due to superior products or pricing. For example, we can think of no reason that an excellent company like Dynamic Materials (Tkr: BOOM) should be trading at three times earnings. It is a good business, there is demand for its products by financially healthy end-users and the company is vigorously paying down long-term debt to less than 25% of capital. The equity market is unpredictable therefore we should not expect it to be predictable. As difficult as it is to ignore the cacophony of prognosticators, we believe the best strategy continues to be carefully researching companies, and buying those that are financially strong, well-managed and make things that people need or want. Then, we diversify our selections across sectors. In the long run, this is the strategy that will be successful.

V
value
COMMENTARY

How do we measure value?

By producing it in the growth of assets, in how our clients view us, in how we create partnership.

[val yoo] n. a quality having intrinsic worth

Are Bonds a Safe Haven?

Equity markets have been hit hard by the recent economic downturn, and investors have been drawn to the bond market in search of guaranteed income streams, principal protection and decreased volatility. Though the fixed income market is generally viewed as a safe haven, investors should be aware that the bond market is not void of risk and actions taken by the government in the form of monetary stimulus and running large deficits will result in inflation. Higher inflation means higher interest rates and tough times ahead for the bond market. Fixed income and bonds are terms often used interchangeably. The return on these instruments can be counterintuitive. A bond is essentially a loan an investor makes to the entity issuing the bond. Issuing entities include: The Federal Government and Agencies State Governments and Municipalities Public and private corporations These obligations can be secured by: The full faith and credit of the issuer A specific project A division of the issuer A collection of assets Todays financial crisis started when the value of the assets securing many Mortgage Backed Securities declined. The buyer of these bonds typically receives fixed interest payments based on the coupon rate, until the bond matures, at which time the issuer returns the principal amount of the loan to the investor. For the owner of the bond, the higher the coupon rate, the higher the interest payments the owner receives. This coupon rate is set at the time the bond is issued and does not change. Due to the fixed nature of the payment stream, the value of the bond holding moves in the opposite direction of interest rates. When interest rates rise, bond prices fall because the buyer of a new bond is able to obtain a stream of fixed payments that is higher than existing ones. In an environment in which interest rates are changing dramatically, the value of a bond holding will also experience wide price swings. Yields on bonds can vary markedly based on several variables, but two important determinants are default risk and interest rate risk. Default risk is the risk that the issuer of the bond becomes unable to pay back

How a bond performs can be counterintuitive. Here are some guiding principles:
Bond return is comprised of two components, interest income and the change in price The interest earned on a bond is a fixed amount The price of a bond fluctuates with changes in interest rates When interest rates go higher, bond prices go lower When interest rates go lower, bond prices go higher The longer the time until the bond matures the more sensitive the price is to a change in interest rates Expectations of higher inflation will result in higher interest rates

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Firm Updates
::

After 21/2 years of outstanding performance as a member of Nelson Roberts Investment Advisors Terrence Boyd, Jr. has accepted a position with the Alameda County Retirement System. We wish Terrence success in his newest endeavor.

COMMENTARY

Are Bonds a Safe Haven? (continued)

the bondholders. In challenging economic times, bond buyers will demand a higher yield as compensation for increased risk of default. Interest rate risk, or duration, is a measure of how the value of a bond holding will change with a move in the level of interest rates. A bond that has a short time to maturity has a low duration and vice versa. The higher the duration of a bond the greater the change in its price with a move in interest rates. A decline in interest rates, for example from 4.0% to 2.0%, will result in high duration bonds appreciating in price more than low duration bonds. The reverse is true with an increase in interest rates; a high duration bond depreciates more than a low duration bond. Today, both default risk and interest rate risk are very high. Default risk is heightened as once predictable cash flows become harder to generate. Inflationary pressures, brought on by extreme stimulus spending, will work not only to erode the value of the bonds fixed interest payments, but additionally cause the Fed to increase interest rates, leading to falling bond prices. We have proactively managed our bond portfolios to reduce these risks. Our bond portfolios are comprised of high credit quality issuances to reduce default risk and low average duration measures, to perform well in an environment where interest rates rise significantly over the next two to three years.

Notable Quotes
Unlike the banking industry, however, our people understand that without real cash profits, there can be no real cash bonuses. Pete Rose, CEO, Expeditors I have failed to become depressed in the last thirty days. Nobody has told us they are changing any of their delivery dates because of macroeconomic conditions. Tim Guertin, CEO, Varian There are a large number of business uncertainties that make the year difficult to forecast. Art Levinson, CEO, Genentech

The Nelson Roberts Investment Advisors quarterly commentary will be available electronically in future quarters. If you would like to continue to receive this piece in hard copy, please contact Tien Tran at ttran@nelsonroberts.com

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Investment Team
Brooks Nelson, CFA Brian Roberts, CFA, MBA Steve Philpott, MBA Dennistoun Brown, MD Ann Oglesby, MD, MBA

WEALTH MANAGEMENT

The Case for Stocks and Against Market Timing

Despite the high anxiety in the equity market and the whipsawing of financial stocks as the government announces each new phase of the bailout, we believe that for long-term investors, a carefully selected equity portfolio is essential. Stock prices reflect the aggregate expectations of market investors and stocks appreciate most significantly when these expectations are exceeded. Therefore, the best time to be a buyer of stocks is when the expectations of market investors are most easily exceeded. In the current economic environment there are low expectations for companies to perform and their stock prices reflect this. Many investors fear that the potential downside of todays market could rival that of the Great Depression. As of the end of January 2009, the rolling 10-year real average return was at the lowest level in history. The market declined on an annual basis at a real rate of nearly -5.0% over those 10 years. The markets real return during the 20 years that began with the market crash of the Great Depression was 0.0%. For todays market to match that same 0.0% return over the 20 year period that includes the last 10 years as well as the next 10 years, the market would have to go UP at real rate of return of 6.5% annually for the next decade1. If we are truly in a stock market environment that matches the returns experienced during the Great Depression, now is a good time for long term investors to be buying stocks and holding them for the next 10 years.
1

When market participants think that current expectations are too negative, the market rallies dramatically. From the lows of early March to today, we have experienced a single session rally of nearly 500 points and an over 1,100 point rally in less than three weeks. A market rally can be swift even if the economic recovery is measured. The following chart from the State of Wisconsin Investment Board shows the dangers of being out of the stock market during these good days. Performance can be dramatically affected by missing the best days of market returns. We continue to believe that the stock market will provide superior long term returns for our investors and are committed to finding the companies that will help us get there. Investing $1,000 in S&P 500 Index 1988-2007
Minus 40 best days Minus 30 best days Minus 20 best days Minus 10 best days

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Jim OShaugnessy, OShaughnessy Asset Management presentation. February 2009.

Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Please contact us for a complete list of portfolio holdings. For additional information on the services of Nelson Roberts Investment Advisors, or to receive our Newsletters via e-mail or be removed from our mailing list, please contact us at 650-322-4000.

1950 University Avenue, Suite 202 East Palo Alto, CA 94303 tel 650-322-4000 web www.nelsonroberts.com email invest@nelsonroberts.com

2009 Nelson Roberts Investment Advisors