1st Quarter 2008 Commentary

7/31/2019 1st Quarter 2008 Commentary

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ASSET MANAGEMENT

A Crisis in LiquidityI it sounds too good to be true, it probably is.This old adage has been repeatedly borne out overthe last year o the credit crisis. It certainly appliesto investment vehicles such as CDOs (collateralizeddebt obligations) and SIVs (structured investmentvehicles), no-money-downhome loans, and the initialestimates or the bankwrite-downs that continueto pile up. On April 1, UBSannounced an additional$19 billion o write-downs.The market greeted thisnews with delight (and anearly 400-point rise) andthe hope that this mightmark the beginning o theend o such eye-poppingnumbers. (See write-downtotals on page 2.)

The root cause o the markets current problems is thelack o liquidity in highly complex fnancial instruments.The events o the last year have looked like a slow-moving train wreck as one car, then another, has alleno the tracks, beginning with the bankruptcy o someo the weaker subprime mortgage companies in early2007 and (hope ully) ending with the recent rescue oBear Stearns. (See timeline on the ollowing pages.)Thus we still believe that caution is warranted.

FIRST QUARTER 2008QUARTERLYCommentary

Inside this IssueASSET MANAGEMENT

: : A Crisis in Liquidity

WEALTH MANAGEMENT

: : A Return to the 70s? Stag ation

FIRM UPDATES

: : Nelson Robertsis Moving

www.nelsonroberts.com | 650.322.4000

The liquidity issues acing the market today are similarto those in 1998, when Long Term Capital Management(LTCM) went under. LTCM had huge leverage in its hedgeund, borrowing $45 or each $1 o capital. One keyund strategy was using arbitrage to proft rom the

spreads between devel-oped and emergingcountry debt. When theRussian governmentdevalued the ruble andde aulted on its debt,investors dumpedemerging market debtand LTCM could not fnbuyers or its emergingmarket bond positions.Similarly, todays mort-gage-based assets arehaving a tough timefnding buyers. Howeverpricing has been a ected

in all markets, even those with more liquid assets. Thespread or di erence between the yields on the entire

municipal bond market and U.S. Treasuries (200% vs. ausualo 50% or fve year munis) was last seen in theyears ollowing the Civil War.

As we look ahead, we believe the crisis in the creditmarket will eventually pass. As the Wall Street Journalpointed out in an editorial earlier this month,thedecades great experiment in direct, unmediated lending

What is Liquidity?

Liquidity is defned as an assets ability to beeasily converted to cash without causing signif-cant changes in price and value. U.S. Treasurybonds and notes are widely regarded as the mostliquid investments in the world. Large capitali-zation domestic and international stocks, such asGeneral Electric or 3M, and large issues o highquality municipal and corporate bonds ollowclosely behind. Generally, the more liquid anasset, the lower the transaction cost.


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1100

1200

FEB. 7, 2007HSBC announces it setaside $10.6 billion for badloans, including subprime

S&P 500 INDEX

1300

1400

1500

APR. 2, 2007New Century,a mortgage broker,files for bankruptcy

JUL. 1Private EquDollar Gen

g

JUL. 17Fed cuts

rate to

Todays mortgage-based assets are havpricing has been affected in all markets

LargestFi teen EquityHoldings

Schlumberger

Matthews Pacifc Tiger Fund

iShares EAFE Index Fund

Procter & Gamble

Masters Select International

Intl Business Machines

Chevron

General Electric

Walgreen

State Street Corp

Fastenal

Utilities Sector SPDR

Emerson Electric

Thermo Fisher Scientifc

Costco

TIMELINE OF THE CREDIT CRISIS

INDEX PERFORMANCE Q108 YTD

Dow Jones Industrials -7.00 -7.00

Standard & Poors 500 -9.44 -9.44

EAFE (international stocks) -8.75 -8.7

Russell 2000 (small stocks) -9.89 -9.89

Lehman Intermediate 3.00 3.00

Lehman Municipal -0.61 -0.61

LARGEST WRITE-DOWNS, IN BILLIONS ($)

UBS $37.0

Merrill Lynch 25.1

Citigroup 21.6

AIG 17.2

Morgan Stanley 13.1

Bank of America 7.7

Deutsche Bank 7.4

Ambac 6.0

Crdit Agricole 6.0

Royal Bank of Scotland 6.0

Socit Gnrale 4.8

Barclays 4.5

Fortis 4.2

CIBC 4.2

Crdit Suisse 4.1Data: Wall Street Journal , Company reports

is undergoing an Adam Smith cleansing. (Adam Smith,a Scottish political economist, wrote The Wealth of Nations in 1776, the quintessential work describing howree market capitalism leads to the creation or elimin-ation o productive capacity or the overall beneft to

society.) Housing prices will fnd a bottom, banks willmove assets back onto their balance sheets, ewer newhomes will be built, and investors will fnd bargains.However, predicting how long this cleansing will takeis impossible. The huge swings in the market and theuncertainty about the timing o recovery invariably causeinvestors to want to sell stocks and raise cash. But market

timing has its own risks. Warren Bu ett concurs: I dontknow anybody who has gotten market timing rightmore than once in a row. Nelson Roberts could sellall o our stocks today, but it is unlikely that we wouldbe disciplined and smart enough to buy them back atexactly the right time. Maintaining our core investmentdiscipline is the wisest course to take; getting yankedaround by the market does not serve us well.


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L. 31, 2007wo Bear Stearnsdge funds filer bankruptcy

AUG. 16, 2007Countrywide drawsdown $11.5 billionfrom credit lines

OCT. 24, 2007Merrill Lynch announces$7.9 billion in subprimewrite-downs

JAN. 11, 2008Bank of America

agrees to buyCountrywide

MAR. 18, 2008FOMC cuts discount rate to 2.5%;

Fed Funds Rate to 2.25%

MAR. 16, 2008At the urging of the FOMC, JP Morgan

offers to buy Bear Stearns for $2.00/share

MAR. 11, 2008FOMC agrees to lend troubled banks

as much as $200 billion

Data: BusinessWeek , Thomson Financial

ough time nding buyers those with more liquid assets .

We have taken the ollowing actions to mitigate theimpact o the current situation:

1. Further reduced our exposure to fnance stocks. Wecontinued on this path this quarter with sales o AIGand McGraw Hill (parent o Standard & Poors).

2. Maintained our holdings in large companies with

low debt, strong cash ow and substantial interna-tional sales.

3. Increased our percentage o U.S. Treasury securitiesin the fxed income portion o our port olios.

4. Avoided junk bonds, auction rate bonds and theentire mortgage-backed securities market.

5. Positioned ourselves in companies that are morerecession-resistant such as consumer staples hold-ings Costco and Target and healthcare equities suchas Gilead and Volcano (a maker o intravascular ultra-

sound or diagnosis and treatment o heart disease).

6. Added the Merk Hard Currency Fund and the Ameri-can Century International Bond Fund to increase thenon-US$ portion o our assets in view o the dollarsongoing weakness.

The Risks o Street Name

Brokerage accounts today are almost always heldin street name. This means that assets in customeraccounts are held in the name o the brokeragefrm. On the brokers books, assets are held or thebeneft o the customer. In the event o a dramati-cally expanded crisis, resulting in bankruptcy o abrokerage, its creditors could come a ter customerassets. We believe this is HIGHLY unlikely, but doacknowledge that it could happen in extreme circum-stances. Holding your assets in an agency accountwithin a trust company is a way to insure againstthis risk. We would be happy to go over the costs,issues and appropriateness o this strategy with youindividually upon request.

Looking Ahead

In our next Quarterly Commentary, we will urther ourdiscussion on the impact o in ation, as well as theimplications or the upcoming presidential election.


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Its no secret the U.S. economy is slowing, but there is a component o this economic cycle thatmay be di erent rom any we have experienced in the last thirty years stagnant growth withrising in ation or stag ation.

Normally, the Fed can count on a slowing economy to lower in ation. Yet despite todays U.S.economic decline, many emerging market countries are experiencing solid growth and strongdemand or raw materials, which in turn keeps prices elevated.

What is Stagfation?Stag ation is a term coined by economists in the 1970s to describe a previously unprecedentedcombination o slow economic growth and rising in ation. From 1970 to 1979, the U.S. experi-enced two years o negative GDP growth with in ation running as high as 13.3%. The spike inin ation was caused by a combination o triggers:

1. Signifcant increases in oil prices imposed by OPEC.

2. Actions taken by the Fed to stimulate the economy by pumping money into the system,urther exacerbating the in ation problem.

While todays economic environment shows some similarities compared to the 1970s, todays market conditions are not nearly as grim. Our current in ation is running close to 4% and we have yet to experience a contraction in GDP growth. That said, the two time periods do share some commonalities.

As in the 70s, todays commodity prices are soaring. Crude oil recently traded above $100 a barrel;in 1979, oil peaked at $72 a barrel (adjusted or todays dollar.) Other commodities like wheat andcorn are also trading at record highs. As a result, a weak U.S. dollar coupled with high energy prices

puts upward pressure on the price o consumer goods like groceries and gasoline.

(continued on following page)

www.nelsonroberts.com | 650.322.4000

WEALTH MANAGEMENT

A Return to the 70s?Vv i s i o n

What is money?At its simplest, it remains a orm o barter, an exchange o energy or goods.At its most complex, its a symbol o mastery, a measure o power. At its centerare people with vision, talent, skill, amilies, children, hope and dreams.

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


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INVESTMENT ADVISORY TEAM

Brooks Nelson, CFA Brian Roberts, CFA Stephen Philpott

Our team o partners provides fnancialpeace o mind to our clients, a select groupo individuals and amilies.

2000 University Avenue, Suite 601East Palo Alto, CA 94303tel 650-322-4000web www.nelsonroberts.comemail [email protected]

Past per ormance is not necessarily a guide to uture per ormance. There are risks involved in investing, includingpossible loss o principal. This in ormation is provided or in ormational purposes only and does not constitutea recommendation or any investment strategy, security or product described herein. Please contact us or acomplete list o port olio holdings.

For additional in ormation on the services o Nelson Roberts Investment Advisors, or to receive ourNewsletters via e-mail or be removed rom our mailing list, please contact Elizabeth Fannon at 650-322-4000or e annon @nelsonroberts.com.

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1st Quarter 2008 Commentary