QUARTERLY

Commentary
FOURTH QUARTER 2008

ASSET MANAGEMENT

Good Riddance to 2008

Ugh, what a year. Our relief that its over is tempered only by our fear of what might be ahead. Just before Christmas, the Bureau of Economic Analysis announced that the economy declined in the quarter ending in September. Everyone knows the 4th quarter was even weaker, so soon they will declare we are when normally liquid markets become illiquid. We have seen other liquidity crunches before. In October 1987, the markets for stocks and options suffered liquidity problems as program trading related to Portfolio Insurance overwhelmed the markets. It took 6 months for this crisis to sort itself out. In the fall of 1998, Long Term Capital, a huge, highly leveraged hedge fund, failed because of a liquidity crisis in foreign currency and debt. Several months later this crisis too was over and the markets were racing to the peak of the Dot Com Boom. The buildup to the current crisis has been much longer, the underlying problems are far deeper and the resulting time necessary to the complete workout will therefore be much longer. The crisis has been exacerbated by the failure of regulators, especially the SEC, and as a result, Wall Street has changed forever. Since May Day 1975, when stock brokerage commissions were deregulated, the rules governing our financial markets have become weaker and weaker. Normally, after such a mess has been created, as in the post Enron period, we would see quickly passed and onerous new regulations. In the

Inside this Issue

ASSET MANAGEMENT

officially in a recession, as if we didnt already know. The banking system is in much better shape after record amounts of government stimulus, support and lending, but still the banks are not lending money out. Prices for energy, most visibly gasoline, industrial commodities, grains, homes and cars are still declining. Market expectations for the next 5 years are for prices, on average, to decline by 0.1 to 0.2% per year. Layoffs and unemployment are rising. The pace of job losses is accelerating with 533,000 jobs lost in November. Might we surpass the 602,000 jobs lost in December 1974? Comparisons to job losses in 1974 need to consider that the labor force is nearly twice as big today so for job losses to be as bad as they were in late 74 Non Farm Payrolls would need to decline by over 1.0 million jobs.

: : Good Riddance to 2008

COMMENTARY

: : Going Forward
WEALTH MANAGEMENT

: : Rule Changes That May Affect You

INDEX PERFORMANCE

Q409 -18.39 -21.95 -19.94 -26.14 4.83 0.74

YTD -31.92 -36.99 -43.07 -33.80 5.08 -2.46

How did we get here? There will be many books written about this and we will be discussing it for the rest of our lives. We have aptly described the markets this year as a slow moving train wreck. The root cause of the train wreck is the most significant liquidity crunch that we have seen in our lifetimes, combined with near total regulatory failure. The markets forgot that the black box models that calculate Value-At-Risk dont work

Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Lehman Intermediate Lehman Municipal

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Every downturn sets the stage for rec massive stimulus will work.

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present case, re-regulation has occurred overnight as the major investment banks have unilaterally subjected themselves to deeper regulation by filing to become or selling out to commercial banks. Without the access to the capital that these moves provided, Goldman Sachs, Morgan Stanley, and Merrill would have failed just as Lehman and Bear Sterns did. The increased regulation was the price they paid to survive. Before the mess is completely cleaned up, we expect that there will be consolidation of the regulatory agencies and greater oversight and restrictions placed on hedge funds and over-the-counter derivative contracts, especially credit default swaps (CDS).

Our biggest fear is that the longer the economy resists stimulation efforts, the greater the chance that consumers truly expect lower prices in the future. For almost all of the last 60 years, our economy has experienced inflation. The expectation that prices will be higher in the future is deeply ingrained in our systems. When in doubt, consumers have generally purchased items to store for a future rainy day, and why not? Its cheaper today than it will likely be tomorrow. If however, consumers truly believe that items will be cheaper tomorrow, then they will begin to think do I really need this item today? And many buying decisions would be postponed on the expectation that one can always buy it for less tomorrow.

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Featured Stock: Volcano Corporation

Stenting a coronary artery involves placing a tiny, permanent mesh device inside in order to keep the artery open, thereby preventing heart attacks. In the last couple of years, scientific studies have demonstrated that there can be problems with both stent placement and late blood clots on the stent itself. Volcano Corporation manufactures and sells devices which provide much clearer and more detailed imaging of the inside of coronary arteries than the traditional coronary angiography test. Intravascular ultrasound, or IVUS, is the companys key product line. Specialized catheters are used to both image the arterys interior and document blood flow across a particular area. The companys ultrasound consoles can be integrated into any cardiac catheterization lab built by companies such as GE, Toshiba and Phillips. Volcano is expanding its capabilities and is now developing optical coherence tomography products, which give even greater resolution and allow cardiologists to see downstream from a lesion as well. The companys revenues come from both new installations of its console systems and repeat sales of its specialized catheters. Volcano currently has over 3,700 systems in cath labs around the world. About 50% of revenues come from outside the United States, particularly from Japan, whose physicians were early adopters of IVUS technology. U.S. cardiologists are now quickly adopting this technology, as studies have demonstrated that stents placed using IVUS have fewer complications down the road. In particular, cardiologists are able to determine whether the stent is completely expanded and snugged tight against the arterial wall. Volcano is actively gaining market share. The company estimates that there are now over 6,000 cath labs world-wide. Between ongoing revenues from new installations, catheter sales and continued development of additional imaging technologies, Volcano is well-positioned to continue its growth, even in the face of the challenging economic environment today.

covery and we are optimistic that the

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Sept. 15. 2008 - Dec. 31, 2008

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A recent Wall Street Journal article pointed out that, historically, it takes years for badly-burned investors to re-enter the market. And in this case, there have been two bear markets (2001 and 2008) in less than a decade. Individual investors own more than 50% of U.S. stock holdings. Or at least they did, before the massive sell-off that has occurred over the last few months. In October, individuals took $72 billion out of stock funds. Additionally, big hedge funds and private equity firms are also abandoning the stock market for alternative investments such as real estate and art. Leuthold Group reports that 71% of the value of the US equity markets is held in zero maturity funds (i.e. money market funds today or cash balances and very short term securities in the 70s). At the bottom in 1982, this measure reached 95% and in 1974 it reached 121%. At both of these bottoms we could earn much, much more on our cash

reserves (6-7% in 74 and 12% in 82). Today these funds, mostly in Treasuries, are earning less than 1%. US Treasury Bills, Notes and Bonds are severely overvalued and we think that sometime in 2009, investors will wake up to the fact that their cash balances are utterly unproductive and the search for yield will begin. This should lead to lower US Treasury prices, much improved liquidity and higher prices in other markets, especially in the more risky corporate and municipal bonds and common stocks. On the positive side, stock valuations are attractive and the government is coming to the rescue. After brutal declines in the market last year, many stocks look very inexpensive on a price to earnings (P/E) or price to book value (P/B). But no one seems to care, probably because there is little faith in the denominators.

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At its simplest, it remains a form of barter, an exchange of energy for goods. At its most complex, its a symbol of mastery, a measure of power. At its center are people with vision, talent, skill, families, children, hope and dreams.

[vizh en] n. the ability to perceive or foresee through mental acuteness

Our hopes for an economic recovery are riding on the back of the bailout, not just by the U.S. but by governments around the world. The magnitude of the US bailout is mind boggling. As lender, investor or insurer, various federal agencies have promised a total of at least $7.8 trillion dollars. Through late November approximately 17% of these funds had been expended. The incoming Obama Administration has already been discussing an additional stimulus package. Spending largely on infrastructure, much like the New Deal programs of Franklin Delano Roosevelt, estimates of the potential size of the program run up to $1 trillion. (See right column). Every downturn sets the stage for recovery and we are optimistic that the massive stimulus will work. We are optimistic, but not certain and so we continue to monitor the indicators that measure deflation expectations and demand. See the chart on the TED spread, which is generally recognized as a measure of credit availability. The 5 year TIP/Note index measures market expectations for future price changes and is frustratingly just below 0%. In the past 5 years this has ranged between 150 and 200 basis points. This inflation expectation index needs to start improving soon or all bets are off. If the TED and TIP/Note indices continue to improve, it will be due to bankers actually doing their jobs by lending to consumers and businesses. As we become more confident that lenders are behaving as if were in the money, you will see us deploying the better than 20% equity cash reserves we now hold and swapping US Treasury issues for much higher yielding corporate or municipal debt.

The Incredible Size of the Bailout

$1.7 Trillion as a Lender: $900 Billion TAF (Term Auction Facility) lends to financial institutions for 28 to 84 days using asset backed securities as collateral. $200 Billion TALF (Term Asset-backed securities Loan Facility) lends to investors using car and small business loans as collateral. $550 Billion Other Loans from the Federal Reserves discount window. $3.0 Trillion as an Investor: $1,600 Billion Commercial Paper. The Fed is now the buyer of last resort in an effort to unfreeze this important market. $700 Billion TARP (Troubled Asset Relief Program). This is the most covered program. Initially proposed by Paulson as a program to buy assets from banks and brokers, this has instead been used as a source of US funds for direct investment in banks equity. $600 Billion FHLB (The Federal Home Loan Bank) is using these funds to buy mortgage backed securities from Fannie Mae, Freddy Mack and Ginny Mae. $53 Billion in loans to AIG. $3.1 Trillion as an Insurer: $1,500 Billion backing senior subordinated debentures issued from now to June 2009. $600 Billion in guarantees of Money Market Funds. $500 Billion increase in FDIC insurance on non-interest bearing accounts. $487 Billion of other promises including costs incurred bailing out Citigroup, Fannie Mae, Freddie Mack, Bear Sterns, and Morgan Stanley. As of late November 2008, $1.363 Trillion as been expended or about 17% of the total.
Source: New York Times 11/26/08

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Firm Updates
::

Congratulations to Terrence and Vanisha Boyd who were married on October 26, 2008.

WEALTH MANAGEMENT

Rule Changes That May Affect You

January 1st marks not only the beginning of a new calendar year, but also puts into effect a number of changes that may be significant to our clients. We have highlighted some of these changes below. Conforming Loan Adjustment. The San Francisco Bay Area qualifies as an area of high cost housing and will see an increase in the conforming loan amounts. Starting in January, conforming loans will be those that total up to $625,000. Home owners with mortgages outstanding near this value should consider refinancing to take advantage of the lower rates available on conforming loans. With the FOMC recent reduction of the Fed Funds rate to 0.00-0.25% conforming mortgage rates have declined to levels not experienced in decades. Defined Contribution Deferral Limits Increase. The amount an employee can elect to defer to an employer sponsored retirement plan (i.e. 401k) is increasing to $16,500. Employees 50 years of age and older can make an additional catch-up contribution of $5,500 for a total deferral of $22,000. Charitable Distributions direct from an IRA. A provision that enables an IRA holder who has reached the age of eligibility (59 ) to make a distribution from an individual retirement account directly to a qualified charity has been extended through 2009. Though there is no direct tax benefit to utilizing this provision, there is an incentive to do so. With an IRA gift to a charity, the participants Adjusted Gross Income (AGI) is not increased as it would be with a normal distribution. There are a number of tax deductions (i.e. medical expenses) and qualifications (i.e. ROTH IRA contributions) that phase out at higher AGI levels. By making a contribution directly to a charity, the participant may be eligible to take advantage of items that would have otherwise phased out. Required Minimum Distribution Relaxed. On December 23, 2008, President Bush signed the Worker, Retiree, and Employer Recovery Act of 2008. One of the main provisions of this act is to eliminate the required minimum distribution (RMD) for the 2009 tax year. The RMD affects retirement account holders older than 70 years of age. Annual Gift Tax Exemption Increase. Any individual can make a tax free gift in the amount of $13,000 to another individual. This is an increase from $12,000 in 2008. Estate Tax Exemption Increase. The total amount of assets that an individual can pass upon death to a non-spouse beneficiary without paying estate and generation-skipping transfer taxes will increase from $2 million per taxpayer to $3.5 million per taxpayer. Perhaps the biggest event this calendar year will be on January 20th when President-elect Barack Obama takes the oath of office. President elect Obama ran a campaign promising change and we anticipate the new administration will hit the ground running.

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Our team of partners provides financial peace of mind to our clients, a select group of individuals and families.
INVESTMENT ADVISORY TEAM

Brooks Nelson, CFA Brian Roberts, CFA Stephen Philpott

COMMENTARY

Going Forward
We will build our investment strategy in 2009 on the following foundation: There is a song from the Broadway musical Oliver that begins Who will buy? This is the question we keep asking ourselves as we discuss the appropriate investment strategy for the gloomy economy. The central assumption behind our purchase of any equity is that other investors will carefully analyze the company, as we have, conclude that it will do well, and therefore also buy the stock. However, we are not at all sure that the usual buyers are going to be coming back into the stock market any time soon, even to buy solid companies that have been dragged down by the macroeconomic environment. The one possible exception to this scenario is sturdy, low-debt companies whose stocks offer high dividend yields. 1. Focus predominantly on large, financially strong, low debt companies who make understandable products that people need, even during a recession. Financial reporting should be absolutely transparent. We will be looking at companies who pay dividends of 3-7%, with the goal of raising our overall dividend payout percentage, as we believe stock price appreciation over the next two years will be modest at best. 2. Begin to look more closely at opportunities in highquality corporate and municipal bonds. Again, this comes back to transparent financial reporting and our confidence in a companys or municipalitys ability to pay both interest and principal over time. 3. After mostly avoiding the finance sector, especially banks in 2007 and 2008, we will make a start at re-investing in the financial sector by choosing a basket of banks and insurers who are getting back to the basics of their businesses and appear well-poised to earn money the old-fashioned way. 4. Consider the population of companies who will likely be involved in major government infrastructure projects. The disadvantage to these companies is the lumpiness of their earnings. However, there are several that should do well who already have major U.S. government projects underway. 5. Keep looking for small, interesting companies, where we have the background and expertise, such as in healthcare, to analyze the potential for future growth. Please do not hesitate to contact us if you would like to discuss how the items highlighted above might be significant for you or your family. We at Nelson Roberts hope you enjoy a Happy New Year filled with health, happiness, and prosperity.

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.

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2009 Nelson Roberts Investment Advisors