2nd Quarter 2010 Commentary

7/31/2019 2nd Quarter 2010 Commentary

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ECOnOmIC OVERVIEW

Default or Devaluation:Solutions to the Problem of Rising Sovereign Debt

The idea that one should actually live within ones meansseems to have become a quaint relic of the 1950s. Mostadvertising today pushes just the opposite approach. Weare urged to buy now an endless stream of goodsand services, ranging from cars, clothes and computersto boats, botox and bicycles. More often than not, forthose who might be a little short of cash, nancing isreadily available.

In a similarly hedonistic fashion, voters around the worldhave opted to elect leaders who promise a chicken in

every pot and lifetime health and retirement bene tsto all. Balancing the budget sounds great until it is yourbene t that is getting reduced or your taxes that aregoing up. Who is going to vote for a would-be leaderwho promises solemnly to raise your taxes? Behavioraleconomics tells us that people will almost always actin their own personal economic self-interest, but havea hard time supporting decisions that hurt them asindividuals yet bene t a greater common good. Thus,governments around the world have agreed to providebene ts and programs to their citizens and the cost ofthese is well beyond their ability to collect tax revenuesconsistent with these promises. Indeed, often leadersare continuing to be elected on the basis of their statedplans to reduce taxes. To ll the gap, almost everygovernment has borrowed money, and some haveborrowed eye-poppingly large amounts.

All of us know personally that there is a limit to how muchmoney we can borrow. Beyond this limit, there is anincreasing chance that we cannot ful ll the obligation torepay the debt. It is harder for us to conceptualize the

SECOnD QUARTER 2010QUARTERLYCommentary

Inside this IssueECOnOmIC OVERVIEW

: Default or Devaluation:Solutions to the Problemof Rising Sovereign Debt

ASSET mAnAGEmEnT

: Second QuarterActivity

mARKET TImInG AnDTOp LOSS ORDERS

: Banes or Boonsfor InvestmentPerformance?

eAtured StoCk

: Schlumberger

Book SuMMAry

: Power Hungry byRobert Bryce

www.nelsonroberts.com | 650.322.4000

limit for an entire country, but that limit does exist andmany countries around the world are perilously close to,if not beyond, this limit.

Governments that become unable to meet their debtobligations have three alternatives: they can defaulton their debt, they can devalue their currency overtlyor they can stimulate in ation, which has the effect ofcovertly devaluing their currency. Default and overtdevaluation are signi cantly more painful and havemarkedly more negative social connotations, so we haveargued that covert devaluation through in ation is themost likely scenario. We have witnessed massive monetarycreation around the world and this will eventually leadto rising prices as long as there are no signi cant govern-ment defaults. The recent bailout of Greece demonstratesthe global intolerance for default. We would do best toprepare for a bout of rising in ation.

(On May 25th we sent our clients a fve-page white pa- per exploring the issues and solutions to the worldwide problem o rising sovereign debt. Please let us know i you would like to review the ull text.)

InDEX pERFORmAnCE Q210 YTD

d w J n s In s ials -9.34 -4.98

S an a & P s 500 -11.41 -6.64

eAFe (in na i nal s c s) -13.65 -12.81

r ss ll 2000 (small s c s) -9.91 -1.93

Ba cla s In m. G v/C i 2.95 4.56

Ba cla s M nicipal 2.07 3.31


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We continue to see signs that th encouraged by consumer-related

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ASSET mAnAGEmEnT

Second Quarter Activity

The Dow Jones Industrial Average uctuated wildlythis past quarter, re ecting the tension and confusionabout whether in ation or de ation was more likely.

At quarters end, the Dow had declined 9.34% and theS&P 500 was down 11.41%. During the rst quarterof 2010, we invested most of our cash when the marketweakened in mid-February. However, we mostly stayedon the sidelines during the second quarter, as we startedthe quarter with 2.5% cash and ended with about thesame amount. We did take the opportunity to add twonew positions to our portfolios while selling our holdingsin one company and trimming our position in another.

The quarterly earnings cycle provided a nice boost inthe price of Fastenal, a company we purchased in early

2007. As the name suggests, Fastenal sells fastenersand other industrial supplies to the construction andmanufacturing industries. The stock performed wellfor us over the three years that we owned it, but thevaluation had risen to a level that we believed was toohigh. We are con dent Fastenal will continue to be agood company, but believed that we would get betterreturns elsewhere in the medium term. We sold theentire position at a pro t in early April. Later that monthwe purchased a position in Royal Dutch Shell. Thisinvestment increases our exposure to the energy sectorand more speci cally to the downstream oil business.We believe that an improving economic picture willbene t energy stocks as demand for energy rises duringup cycles. Royal Dutch Shell also pays an attractivedividend of 6.4%. Despite the ongoing oil leak in theGulf of Mexico and the issues with deep-water drilling,consumers are not going to stop using oil and gas.

Within each major equity sector, an improving economicenvironment will disproportionately bene t smallercompanies relative to their big company competition.

The stable balance sheets and predictable revenuestreams of large cap technology companies providedassurance to investors during the dif cult market of2009. Now that the economy has stabilized, manycustomers of technology companies are looking toimprove their internal processes by implementing new

MEASURES O

Source: Thomson Reuters/University of Michigan

1966 1971 1976 1981 19

Index of C

Consumer Con dence Index

Index, Feb-1966 = 100

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omestic economy is improving and are tistics.

ER ATTITUDES

80

60

40

20

0

Index, 1985 = 100

91 1996 2001 2006 2011

nt

100

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technology. This is resulting in growth opportunitiesfor technology sector companies. We continued ourtransition to smaller tech stocks by trimming our posi-

tion in IBM (market cap of $166 billion) and putting theproceeds into Cavium Networks (market cap of $1.21billion). Cavium designs and develops semiconduc-tors for use in routers that handle feature-rich internettraf c. We discussed in the rst quarter commentarythe increased use of the internet for robust applications

such as cloud computing and video streaming. Theseapplications require more dynamic solutions focused onsecurity and data integrity. Cavium helps provide these

solutions and we expect it to bene t signi cantly ascompanies enter an upgrade cycle.

The bond market continues to add to investors tension.Less secure bonds, which offer only slightly more returnthan US Treasuries, are underperforming as investors arestarting to demand more return to take on risk. At thesame time, problems overseas are causing a ight tothe safety of the US Dollar and foreign investors areusing the dollars they buy to acquire US Treasury bonds.As a consequence, the yields on Treasury Notes withmaturities greater than 5 years continue to languish

at the 2-3 % level. Short term yields are worse thananemic. Money funds are paying nearly nothing. This isseverely crimping investors cash ow and making manystocks dividends juicy by comparison.

We continue to see signs that the domestic economyis improving and are encouraged by consumer-relatedstatistics. The change in non-farm payrolls was positivefor the rst time in over two years, the unemploymentrate has stabilized (although it remains distressinglyhigh) and consumer con dence has improved steadilyover the last twelve months. Though each of these

statistics are below the levels we would like to see, theyare at least trending in the right direction and point to acontinued market recovery.


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Buy low and sell high is an old market adage thatseems quite obvious, but it turns out that it is hard todo. There are countless market newsletters, blogs and

websites that promise their followers the tools neededto time the market, but few, if any, have been provento work over the years. Short-term market movementsare not easy to predict and the market has a way ofhumbling even the most experienced investor. Surprises,both good and bad, lurk around every corner.

market ti i gMarket timing is de ned as making buy or sell decisionsbased on predictions of future stock price movements.This is usually done by examining recent price and volumetrends or economic data, but some investors make

decisions just on gut feel. The dif cult aspect ofmarket timing is that investors have to be right twice:they need to make the correct decision about when toget out of the market, and they also need to make theright decision about when to get back in so that theydo not miss the next run-up. Academic studies havedemonstrated that it is exceedingly dif cult to do thisand practically impossible to get it right on a consistentbasis. Fear and greed have a strong tendency to preventinvestors from buying at the bottom and selling at the top.

Sto -loss orders

A stop-loss order is designed to automatically sell asecurity if it reaches a certain price. Stop-loss orders areused by investors to protect stock positions if the marketfalls. On the surface, a stop-loss order makes sense asa means to hedge losses, but in practice a stop-loss canback re and prove to be costly. For example, on May 6(the Flash Crash) many stop-loss orders were triggeredwhen the market dropped more than 20%. The market

fell so quickly that many orders were lled well belowthe trigger price. Most stocks then rebounded, leavinginvestors who used stop-losses sitting on cash. Once a

trigger price is hit, the stop-loss order becomes a marketorder. This means the trade is automatically executedat the market price, which could be well below theintended sell price.

Many stock pickers have built their reputations on placingbig bets and predicting market crashes. The ones thatguess correctly make the headlines, but the others wholose money are rarely heard from. We believe buildingwealth through successful stock selection takes in-depthresearch, analysis and a disciplined strategy. As we haveseen repeatedly during the last two years, the market is

volatile and returns are not guaranteed. However, webelieve that using a long-term, company-based approachremains one of the best methods to make money.

mARKET TImInG AnD STOp LOSS ORDERS

Banes or Boons for Investment Performance?

0 $2,000 $4,000 $6,000 $8,000 $10,000

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

Continually invested

Vv a l u e 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


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: : Intelligent saving and sustainable growth need not be a contradiction. G man Chanc ll Ang la M l during Junes G-20 Summit

The blowout of the Deepwater Horizon drilling rig in the Gulf of Mexico on April 20th has created theworst environmental disaster in US history. A temporary injunction halting the Obama administrations banon offshore drilling was issued by US District Judge Martin Feldman on June 22. That injunction is nowbeing appealed to the 5th Circuit Court of Appeals in New Orleans. These legal actions and the uncertainty

surrounding the ultimate outcome will effectively end offshore drilling activity in the immediate future.However, as we observe in our review of Power Hungry (see Page 6), the US and the rest of the world willcontinue to rely on fossil fuels for energy into the foreseeable future.

World consumption of oil will continue to rise as developing countries require more and more power. Therefore,drilling for oil will have to continue. Geologists use seismic testing data to characterize the structures deepbelow the earths surface. Small explosions are set off and the density of the underlying rocks can beestimated by the speed at which the shock waves radiate. Using this information, geologists can choosethe optimal site for an exploratory well. Once drilled, instruments are sent down the well to measure rockporosity, pressure and oil content. Geologists can then evaluate how much oil is likely recoverable from agiven formation. Schlumberger makes seismic testing equipment, performs well data measurement andanalysis and many other oil eld services. Or, as the company itself says: Schlumberger is the worlds leading

oil eld services company supplying technology, information solutions, and integrated project managementthat optimize reservoir performance for customers working in the oil and gas industry. Schlumberger is abig company, employing 77,000 people in 80 countries. Its expertise will be needed for years to come.

FEATURED STOCK

Schlumberger (SLB)

70

65

60

55

50

2010 Bloomberg Finance L. P.

JULY 6, 2009 JUNE 30, 2010Schlumberger (SLB)

JUL AUG SEPT OCT NOV DEC JAN FEB APR MAY JUN

2009

75

LAST PRICE

HIGH ON 04/29/10

AVERAGE

LOW ON 07/07/09

55.34

73.15

61.96

49.20

2010

MAR


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1950 University Avenue, Suite 202East Palo Alto, CA 94303tel 650-322-4000web www.nelsonroberts.come ail [email protected]

Past performance is not necessarily a guide to future performance. There are risks involved in investing,including possible loss of principal. This information i s provided for informational purposes only and doesnot constitute a recommendation for any investment strategy, security or product described herein. Pleasecontact us for a complete list of portfolio holdings.

For additional information on the services of Nelson Roberts Investment Advisors, or to receive ourNewsletters via e-mail or be removed from our mailing list, please contact us at 650-322-4000.

2010 Nelson Roberts Investment Advisors

In our discussion of Schlumberger, our featured stock for this issue of the Commentary, we alluded to the continuedneed for hydrocarbon-based fuels for the foreseeable future. With all the discussion about alternative energysources, such as wind and solar power, why are we not looking at investment opportunities there?

Robert Bryce answers this critical question in his new book, Power Hungry. Bryce is a journalist who has been writingabout energy issues for over twenty years, is managing editor of the online magazine Energy Tribune , and is asenior fellow at the Manhattan Institute. According to Bryce, the energy business is governed by four imperatives:power density, energy density, cost and scale. Power density is the amount of power that can be harnessed ina given unit of volume, area or mass (for example, watts per meter squared). Energy density is the amount ofenergy that is contained in a given unit of volume, area or mass (joules per kilogram). The higher the density ofeach, the better. The relationship between the four imperatives is as follows: if a source has low power density,it invariably has higher costs, which makes it dif cult for that source to scale up and provide large amounts ofenergy at reasonable prices.

A quick review of physics: energy is the ability to do work, power is the rate at which work gets done. The morepower we have, the quicker the work gets done. So we use energy to make power, and power allows us to dothings, like sit in an air-conditioned house eating ice cream, that make us happy, wealthy and comfortable.

Hydrocarbons provide cheap, reliable, abundant power.

Renewable energy is not useful unless it can be converted to renewable power. As consumers, we demand powerthat be accessed at speci c times of our choosing. To do this, the power must be able to be stored. Right now,solar and wind can provide neither reliable nor abundant power. Both must have back-up hydrocarbon systems(whether natural gas or coal) to generate power when the wind is not blowing or the sun is not shining. Moreover,wind and solar farms take up huge amounts of real estate for the amount of power they are able to generate.

The global energy sector totals $5 trillion and is the worlds single biggest business. It will only get larger as developingeconomies demand the same cheap, abundant, reliable electrical power that we take for granted. As Bryce pointsout, try as they might, regulators cannot change the laws of physics. He believes that our best bets are natural gas(near-term) and nuclear power (long-term). However, regardless of the types of energy sources we ultimately convertto over the next decades, transitioning from a hydrocarbon-powered economy will be a lengthy, expensive process.

BOOK REVIEW

Power Hungry by Robert Bryce

Investment TeamBrooks Nelson, CFABrian Roberts, CFA, MBASteve Philpott, CFP , MBADennistoun Brown, MDAnn Oglesby, MD, MBA

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2nd Quarter 2010 Commentary