QUARTERLY

Commentary
third quarter 2011

economic overview

The Era of the Sovereign Debt Crisis

History books will call this era the Sovereign Debt Crisis. In the last two months, the focus has shifted from the US governments debt limit and credit rating downgrade to daily reports of the markets concern Greece has waited too long, been too generous with its benefits and lied about its borrowings. Greece reminds us of the star athlete who constantly violates team rules because he knows the coach cant afford to kick him off the team. This is a country that claims to have adopted financial austerity yet fires no government employees. Financial reporting from Greece is suspect at best and false at worst. The Greeks just keep borrowing money with essentially no intention of changing their ways or paying it back. Now the country is widely expected to default on its debt obligations. But how can a country equal in population to Los Angeles County with an economy the size of Wisconsins be threatening world financial stability? Why doesnt the EU just kick Greece out and force that countrys leaders to decide what to do?

Inside this Issue

economic overview

about a possible default by the government of Greece. The US debt limit debate and the European debt

: : The Era of the Sovereign Debt Crisis

asset manaGement

situation are rooted in the fundamental problem that governments world-wide are wrestling with: government payouts for retirement and healthcare are rising and will soon be unsustainable. Most developed countries have birthrates that are just high enough to maintain current population levels and medical advances are increasing average lifespan. Consequently, the ranks of the retired are rising as a percentage of the total population. Because people use more healthcare services as they age, healthcare costs are increasing at twice the rate of current economic growth. During this time of rapidly rising benefit costs, economic malaise is reducing governments revenues, exacerbating the problem and adding urgency to the need to address it. In the US, politicians are continuing to dodge the hard decisions that must be made. No one wants to be the first to propose legislation to slow the growth of Social Security and Medicare spending, despite good bipartisan commission reports that map out a sensible approach.

: : What Do You Buy in This Environment?

Fixed income

: : US Downgrade in Perspective
Featured equity

: : Verizon Communications, Inc.

investment themes

index PerFormance Dow Jones Industrials Standard & Poors 500 EAFE (international stocks) Russell 2000 (small stocks) Barclays Interm. Gov/Credit Barclays Municipal

q311 -11.50 -13.87 -18.91 -21.86 2.39 3.82

ytd -3.92 -8.69 -14.59 -17.02 4.92 8.40

: : Nanotechnology

www.nelsonroberts.com | 650.322.4000

Sir John Templeton once said Bull marke mature in optimism and die in euphoria.

top

economic overview

FiFteen Holdings
IShareS Intl emergIng marketS tJX CompanIeS oraCle Corp CoStCo Corp VerIzon CommunICatIonS DIageo plC CheVron Corp SeCtor utIlItIeS SpDr IShareS S&p Small Cap royal DutCh Shell IShareS eaFe InDeX payCheX InC. emergIng aSIa paCIFIC SpDr Jm SmuCker Co. Colgate palmolIVe Co.

The Era of the Sovereign Debt Crisis (contd)

The reason is that French and German banks would suffer badly if Greece defaulted or left the EU. Greeces public debt is over 300 billion euros ($400 billion) at todays exchange rates. This is about 142% of the countrys GDP, which is 7% less than it was a year ago. A significant amount of this debt is held by French and German banks. If Greece defaults, the banks large losses would cause them to reduce lending to other weak EU members like Portugal, Ireland, Italy and Spain. One of these countries could then default, setting off a domino reaction and another liquidity crisis like the one the world experienced in 2008. We think the worst case outcome (Greek default, Greece leaving the EU, swapping the euro for the drachma and promptly devaluing the drachma) for
us treasury yieLd vs. cPi

the Sovereign Debt Crisis is being priced into the markets. There are alternative, happier outcomes that would cheer up the markets. It is possible, but not likely, that the European monetary union might expand to include a fiscal union where control of debt, deficits and debt guarantee is maintained by the union with the union as the future borrower. Another scenario is that a Greek default could precipitate a Portuguese bailout with an Irish rebound and no domino effect. Eventually, rational behavior will return. Investors will select stocks because they have growing earnings and will look beyond companies that make basic necessities. And, just as they have for most of the last fifty years, buyers will demand, at a minimum, a real positive return of 2-4% from US treasury notes and
%
15

June 30, 1960 September 30, 2011

bonds, rather than the current T-bill return of 0.01%. In the meantime, we could all benefit from watching, reading and downloading less of the bad news of the moment and taking a longer view. As Sir John Templeton once said Bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria. We think pessimism is nearing an apogee.

10 yr. treasury cPi

10

5 3.7 1.9 0

10.0

sPread

8.0 6.0 4.0 2.0 0.0 -1.7 -4.0 -6.0

1960-64

1965-69

1970-74

1975-79

1980-84

1985-89

1990-94

1995-1999

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2005-09

2010-11

2011 Bloomberg Finance L. P.

ets are born in pessimism, grow in skepticism, We think pessimism is nearing an apogee.

asset manaGement

What Do You Buy in This Environment?

In our first half commentaries this year, we wrote that we were concerned about inflation and the negative effect it would have on interest rates and bond prices. We also said that the market would experience an increase in the aggregate value of stocks that matched the rate of earnings growth from corporations. Instead, despite increased inflation (the CPI has risen from 1.5% to 3.8% and the PPI has increased from 3.8% to 6.5%), interest rates have fallen, dropping to a 1.9% yield on a 10-year Treasury note. And the stock market has declined 8.7% in the face of strong corporate earnings and profit growth of 14.4% for the S&P 500. The stocks of small companies have been hit even harder, now down 17.0% since the beginning of 2011. What is going on here? The market is not trading on the fundamentals of individual corporations but rather on the concerns about US domestic growth and the unknown implications of a potential debt default in Greece. In such a fearful environment, good company performance does not seem to matter. Irrational behavior is everywhere. For example, Varian Medical (VAR) reported record sales and profits and a growing market share in a growing world-wide market last quarter. On this news, the stock has dropped 26%. Investing in a market that behaves more or less rationally is challenging enough; participating in one that is irrational frustrates everyone. Despite our frustrations, however, we are confident that the stock market will
1971-74 1975-79 1980-84 1985-89 1990-94 1995-99 2000-04 2005-09 2010-11
2011 Bloomberg Finance L. P.

ultimately reflect the intrinsic value and performance of each company. This value is increasingly attractive. Stock dividends now exceed the return on a 10-year Treasury notes and are growing. We have therefore added to the positions we hold in Diageo, Verizon (see featured stock on page 5) and XLU . Diageo has a 4.22% dividend yield, Verizon pays 5.40% and XLU 3.98%. We continue to research companies that are industry leaders, financially strong and pay solid dividends. It is impossible to know when the fear that is currently gripping the market will ease. While we are waiting, rational market participants (like us) will focus on company fundamentals and be diligent in our research and patient in our approach.
us treasury yieLd vs. s&P 500 div. yieLd
January 15, 1971 September 30, 2011

%
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10 yr treasury s&P div. yieLd

14.0

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4.0 2.2530 1.9831 0.0

V
vision
Fixed income

What is money?
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

US Downgrade in Perspective
The recent downgrade of the US debt rating by Standard and Poors marked the first time in the nations post-World War II history that the US has not held the highest rating of AAA. Prior to that, ratings agencies did not exist. The change has raised concerns that the US dollar is in jeopardy of losing its status as the worlds reserve currency and several countries have called for a new global currency. However, the fact is that the US remains the most stable economic global power and as a result the dollar will continue as the reserve currency for the foreseeable future. Sovereign country credit downgrades are not as unusual as people might think. Nine sovereign borrowers have lost their AAA rating since 1998. Spain lost its top rating in 1990, regained it, only to lose it again in 2009. Japan lost its AAA rating in 2001 but has never regained it. Canada and Australia were both downgraded, but were able to regain AAA status after several years of fiscal discipline. There are currently fourteen countries with AAA ratings, although four are under credit watch, meaning a rate cut could be pending. On the first trading day after the US downgrade was announced August 5th, the yield on the 10-year Treasury note fell from 2.55% to 2.31%. The market was not concerned that the US would have difficulty paying its bills or making interest payments. If that were the case, interest rates would have risen as investors demanded higher yields for the increased risk. The downgrade was
remaininG countries with aaa credit ratinGs By s&P
Australia Austria Canada Denmark Finland France Germany Hong Kong Netherlands Norway Singapore Sweden Switzerland United Kingdom

based on skepticism that Washington policy makers would actually make significant progress on reducing the deficit, given the acrimony we witnessed during the debt ceiling debate. The US government cannot continue to borrow money the way it has been and this country will certainly have issues with debt as long as major policy directions for taxes and entitlement spending are unresolved. In 2001, the US dollar made up approximately 70% of all foreign exchange reserves around the world. Today, that figure is down to about 60%. This compares to the euro at 26.6%, the next largest reserve currency and one that certainly has its own problems. The day when the world decides that the dollar is not a safe place to deposit money may arrive, but it will not be anytime soon.

www.nelsonroberts.com | 650.322.4000

Firm Update
::

We are pleased to announce the addition of a new employee, Edwina Tran, who joined the firm in July as a portfolio managers assistant. A recent graduate of the University of California Davis, with a degree in Managerial Economics, Edwina has returned to the Bay Area to launch a career in investment management.

Featured equity

Verizon Communications, Inc.

Verizon is the market leader in a growing and very profitable business. For nearly a decade it has been our sole holding in the telecommunications industry. The shares pay a 5.40% dividend and are only half as volatile as the S&P 500 index. In a world where money market funds pay 0.01%, it is a stock we love to own. Verizon is a huge business. 2010 revenues were nearly $107 billion and the company employs 196,000 people. It sounds like an elephant-sized, stodgy corporation, but it is not. What is most remarkable about Verizon is its ability to evolve and transform itself in an industry that is changing at a dizzying pace. Verizon was formed in 2000 when GTE and Bell Atlantic merged. At the time, the combined company had $70 billion in revenues, 53% of which came from the wireline or POTS (plain old telephone service) business. POTS is going the way of the buggy whip. Most of our children will never have a traditional telephone line. Today just 15% of Verizons revenue comes from POTS. The rest comes from the best cell phone service in the US and from FiOS, Verizons fiber optic broadband internet and TV network. FiOS service provides customers with fiber optic cable all the way to the TVs and computers in their homes. This service gives unrivaled speed and quality.
2004
Revenue % Wireline % Wireless % FiOS/Strategic % Other Local Lines Cell Phone Customers $70 billion 53% 40% 0% 7% 55 million 40 million

2010
$107 billion 15% 63% 14% 8% 26 million 106 million

The proliferation of smart phone and tablet devices such as the iPhone, Blackberry, and iPad and the migration of databases to the cloud (storing information over the internet instead of keeping it on the hard drive of the computer on your desk) point to the continued growth of wireless and broadband communications. As the leading high quality provider of these services, Verizons growth seems assured.

www.nelsonroberts.com | 650.322.4000

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

investment themes

Nanotechnology
For those of you of a certain age, nano may be one of the words you recall Mork saying to Mindy. However, it is in fact one-billionth of something and is most often used to refer to one-billionth of a meter. Nanotechnology is the development and manufacture of materials at the nanometer (nm) scale. To get an idea of how small a nanometer is, a virus is about 50-100 nm in diameter. A single hemoglobin molecule is 30 nm wide. There are two reasons that we are hearing so much about nanotechnology now: materials can be reliably made at the nano scale (that is, they are manufacturable and reproducible) and the tools to see nanoparticles are available and getting better all the time. Current predictions are that nanotech materials will be incorporated in more than 50% of new products by 2015. Moreover, 15% of all global goods will have some type of nanomaterials in them, which represents a $3 trillion market. There are four key features of nanomaterials that are driving this market: 1. Nanoparticles are tiny, which means that a lot of them can be packed into a small space. 2. Nanoparticles have a large surface-to-volume ratio, so there are a lot of atoms on the surface and the surfaces can be used to carry other substances or interact with other molecules in a certain way. Moreover, surface forces dominate over bulk forces (like gravity) and this allows particles to stay in solution indefinitely. 3. The wavelength of visible light is greater than the radius of nanoscale structures, so light scatters and diffracts when interacting with them. 4. Nanoparticles exhibit unique chemical bonding properties (for example, the type of carbon-carbon bonding seen in buckyballs and carbon nanotubes does not occur at the macro level). As a result, nanomaterials have physical properties such as incredible strength but very low weight. Pound for pound, carbon nanotubes are stronger than steel. Industries in which nanotechnology is already playing a role include medicine, sporting goods, clothing, cosmetics, appliances and electronics. In medicine, silver nanoparticle-impregnated bandages are being used to decrease infection. Baseball bats, golf balls, tennis rackets, skis, and bicycles are all benefitting from the much greater structural strength and lighter weight of carbon nanofibers and carbon nanotubes. In microelectronics, nanotechnology is being used every day to make the smallest transistors. Manufacturers may soon understand how to create self-assembling transistors, a game-changing technology.

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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2011 Nelson Roberts Investment Advisors