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QUARTERLY COMMENTARY THIRD QUARTER 2006

A NEW HIGH! (NEARLY)

The 3rd quarter produced sparkling returns for themarkets with both U.S. Stocks and U.S. Bondsposting positive returns. The Dow Jones IndustrialAverage nearly closed at a new high on the lasttrading day of the quarter, but settled instead for a 3 rdquarter return of 4.74%, its biggest quarter since1998. The index had an intraday high of 11,741 forthe quarter, but could not close above the previoushigh of 11,722, set on January 14, 2000. While the30 stocks in the Dow Jones are back near recordterritory, the rest ofthe U.S. equitymarkets are farfrom breakingrecords. The S&P500 closed at 1,335 still 12.5% belowthe high set onMarch 24, 2000 at1,527. Even moredramatic, theNASDAQ closedthe 3rd quarter at2,258 55% below

its high of 5,048 onMarch 10, 2000. Small stocks, though still positive,posted a second consecutive weak quarter. TheRussell 2000 appreciated only 0.44% in the 3rdquarter. After a strong start to the year, foreignequities were up 3.99%, underperforming the U.S.markets for the first time in two years.

THAT WAS THEN

Much has changed since the markets last traded atthese levels, most significantly is the optimismsurrounding the equity markets. In January 2000, the

S&P 500 was trading at a price earnings ratio (P/E)of 31.5. Todays P/E ratio of 17.5 is indicative ofboth the significant growth of corporate earnings overthe last 6 years and the fact that investors areapplying far more reasonable valuation metrics.

The resilience of the financial markets since the DowJones last traded at this level has been impressive. Inthe years since the last high, investors have enduredthe experiences of 9/11, hurricanes Katrina and Rita,the Indonesian tsunami, the start of two wars,

corporate scandals led by Enron and WorldCom, the

decline in interest rates to 50-year lows, the rise of oilfrom $28/bbl to $77/bbl, a housing boom, the growthof hedge funds, and many mergers and acquisitions.Through it all, the U.S. consumer has continued tospend retail sales are up 25%, and businesses havecontinued to grow corporate profits are up over100%.

3RD

QUARTER IN REVIEW

The 3rd quarter started off weak as a number ofcompany earnings reports disappointed market

investors resulting inprecipitous one-daystock price drops of 10-20%. Dow Jones

components:Minnesota, Mining &Manufacturing (tkr:MMM) and Intel (tkr:INTC) were among thenames that exemplifiedthis action. The marketalso responded toweakness in individual

consumer-oriented

companies, which havebeen a source of strength for many consecutivequarters. Companies like Tiffany (tkr: TIF), WholeFoods (tkr: WFMI), Cheesecake Factory (tkr:CAKE), and Starbucks (tkr: SBUX) all hadexaggerated declines after disappointing earningsreports.

The market rally began in mid-July in response toFed Chairman Ben Bernankes July 17th speech to theSenate Banking Committee. He suggested that theFed might end its two-year series of rate increases at

their next meeting. Chairman Bernankes commentswere buoyed further with earnings that beat analystexpectations, most notably Goldman Sachs (tkr: GS)and Oracle (tkr: ORCL).

In our portfolios, the big winners in the quarter camefrom the technology sector. Oracle (tkr: ORCL),Motorola (tkr: MOT), and Cisco (tkr: CSCO) allposted stock gains in excess of 20%. The energysector, after an extremely robust first half of 2006,contributed the biggest decliners in the quarter as

Dow Jones IndustrialJanuary 2000 High

9/11/01

Source: Bloomberg

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crude oil prices fell to $60/bbl. Marathon Oil (tkr:MRO) and Schlumberger (tkr: SLB) each fell justover 10%.

A CHANGE IN DIRECTION

On the heels of a strong 2005, commodity price gainscontinued in the first half of 2006, peaking in mid-

May. But after reachingthese highs, gold, oil,and natural gas, as wellas the entire CRB indexfell in the 3rd quarter.The CRB, havingreached a 25-year highwas down 12%. Gold,which peaked at$714.8/oz, was down 16.2%. Oil dropped from theJuly 14th high of $77/bbl to $62.9/bbl a decline of18.3%. The decline in oil can be attributed to

Chevrons (tkr: CVX) announcement regarding thediscovery of the most significant new domestic oilfind since Prudhoe Bay in 1968. Its Jack 2 Well inthe deep water of the Gulf of Mexico is estimated tohold nine billion barrels.

DEFICITS, THE DOLLAR, AND INTEREST RATES

We highlighted the growing problem of the U.S.Current Account Balance in our last quarterlycommentary. If the trade balance continues to widen,we believe the U.S. dollar will suffer furtherweakness. To hedge portfolio exposure to this risk,we established a position in an international bondfund during the quarter. The American CenturyInternational Bond Fund (Tkr: BEGBX) invests innon-U.S. sovereign debt and will appreciate in valueif the U.S. dollar continues to weaken.

The Federal Reserve raised rates at its June 29thmeeting for the 17th time, and then made the difficultbut very significant decision to leave rates unchangedat the August meeting. The central bankers are tryingto walk the fine line between keeping inflation undercontrol and pushing the economy into a downturn aswe see signs of both accelerating inflation and

moderating growth. Bond securities rallied onexpectations of this pause and yields have continuedto move lower. We think the bond market is ahead ofitself, even if the Feds next move is to lower rates inthe spring.

ETHICS IMPACTING THE MARKET

The recalibration of the ethical landscape in corporateAmerica continues. We have seen daily reminders ofthe focus on ethical behavior with Hewlett-Packards

board of directors and CEO making news inconnection with the companys investigation intoboardroom leaks. Recently the F.B.I. announced theywere aiding the Justice Department in itsinvestigations into the options backdating scandal.We feel the escalation of this issue by the SEC and

the FBI is a significantdevelopment. Weexpect to see the moreegregious examples ofcorporate fraudpunished with bothprison time and fines.

After several examplesover the last year of unethical or fraudulent behavioron the part of a few hedge funds, this quarter we haveseen headlines driven by extremely large investmentlosses. For example, Amaranth, a fund with about$9.5 billion in assets, lost $6 billion over oneweekend in early September, due in large part toerroneous speculation on the direction of natural gasprices. Though Amaranths investors sufferedsignificant losses, the liquidation of the firmspositions was orderly and did not cause a dramaticmarket reaction.

FALL EXPECTATIONS

With the equity markets posting solid returns throughthe first three quarters of 2006, our expectations forreturns through the remainder of the year are muted.

The economy is slowing, the current conflicts in theMiddle East remain unresolved, and the mid-termelections will likely create more questions thananswers. Corporate earnings growth will continue todrive the direction of the stock market. We haveacted on expectations for a lackluster 4th quarter byincreasing our cash holdings. As the market ralliedin the 3rd quarter, we trimmed holdings in Pepsi (tkr:PEP), McGraw Hill (tkr: MHP), Oracle (tkr: ORCL),and our S&P small cap 600 iShare (tkr: IJR). Ourattention is focused on the handoff between theindividual and the corporate consumer and we look

for opportunities to profit from that exchange.

SUSTAINABILITY: AN INVESTMENT THEME

Brooks Nelson recently presented on the investmenttopic of Sustainability. If you are interested inreceiving a copy of the presentation slides, pleasecontact Elizabeth Fannon at (650) 322-4000 orefannon@nelsonroberts.com.

Index Performance Q3 06 YTD

Dow Jones Industrials 5.34 10.85

Standard & Poors 500 5.66 8.52

EAFE (international stocks) 3.99 14.97

Russell 2000 (small stocks) 0.44 8.73

Lehman Intermediate 3.19 3.01

Lehman Municipal 3.41 3.69