The Quantum View

Third Quarter 2009

What Lies Ahead?

By Mat Johnson

"The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant."
— Arthur C. Pigou

For many investors, last year was probably less a breath of fresh air than an opportunity to finally exhale. While the end of year performance of the global stock markets was certainly far better than in 2008, the year began with a great deal of fear, uncertainty and doubt as it relates to investor sentiment and their long-term commitment to equity investing.

From late spring of last year the market's performance was little short of spectacular, although investors continued to meet the market's advance with a great deal of skepticism. One trend that captured this persistent skittishness toward equities was the continued withdrawal of assets from equity mutual funds, to the tune of nearly $10 billion for all of 2009. On the other hand, investors committed nearly $400 billion into the perceived safe haven of bond funds. So while your peers may be talking about their "big year" in the market in '09, the numbers suggest that, more likely than not, they were actually selling stocks not buying them.

In fact, by one metric — the ratio of cash to the total U.S. stock market value — investors are closer to being in panic mode than willing equity investors. At the end of 2009, this ratio, commonly referred to as "cash on the sidelines" intended to measure the pent-up demand for equities, amounted to 25%. While this is down sharply from the 45% in February 08', it is still above the then record level seen in early 2003, (prior market bottom), and far above the typical 10% experienced over the period from 1984-2000. Again, given the net withdrawal of funds from the market, the ratio came down solely as a result of the market's advance, leaving the latent demand of those cash balances sidelined.

This persistent uncertainty toward investing in equities may very well be the result of having to live through two sharp market declines within the past 10-years.

An additional concern could also be self-preservation. After all, while economic conditions may be stabilizing, they continue to rate as poor, as measured by unemployment levels and the general lack of business investment.

While the economy has shown clearer signs in recent months of being on the mend, there remains a great deal of concern surrounding the sustainability of the economic recovery. With each tick higher of the stock market, a view is forming that without clear signs of economic improvement, the market's advance may prove increasingly difficult to sustain in the year ahead. This is something we touched upon last quarter in "Could it be Any Clearer?"

There actually appears to be two camps developing with respect to a big picture view: those that see the deep cuts by companies in areas such as inventories, employees and investment generally, as being over done, which will lead companies to have to "restock and retool," thereby kick starting the economy toward sustainable growth.

The second view is that after a couple of quarters of restocking and perhaps experiencing some pent-up demand by consumers, the economy will settle into a long-term path of sub-par growth, neither providing an incentive for companies to invest, nor hire, and leave the economy susceptible to a "double-dip." The primary culprit behind sub-par growth centers on consumers' continuing need to purge themselves of debt, and no longer having the wealth tailwind from either real estate or investments at their back, from which they can borrow from themselves to consume. Consequently, consumers will be bigger savers and starve the economy of their spending dollars.

Clearly there is a common point of agreement; that in the near term the economy should continue to strengthen. The point of disagreement is: what happens over the long-term?

While there clearly are impediments to the economy growing strongly over the long-term, they are not insurmountable, and may prove to be a favorable obstacle to overcome.

One such long-term issue is the colossal mountain of public sector debt that has accumulated resulting from the U.S. government's actions to save us from ourselves, or more specifically, from consumers' years of binging on cheap credit, now turned into burdensome debt. The task ahead will lie with how this public sector debt is managed downward, without taxing away the economic recovery, or producing a surge in inflation — another, and arguably more vicious, form of taxation.

The true determinant of long-term economic health however, will be in how businesses invest in their futures moving forward. Throughout the market's 2009 advance, companies were largely focused on "rightsizing" to the new economic realities; limiting production, reducing costs, and restoring profitability to the current levels of economic demand.

Today there is still some lamenting that sales aren't rising, but the reality is that as investors, what we get isn't sales, but the residual profits. Remarkably, many companies are currently recording their highest levels of profitability, which is how they are able to generate profits at all amidst the near 20% collapse in sales versus one year ago.

Most companies have accomplished profitability through drastic cost cutting and rapid downsizing of their businesses. While this clearly impacts individuals as employees and consumers in the near term, it strengthens the long-term viability and profitability of these companies — and importantly, their capacity to be long-term employers.

From an economic perspective, we too, view the outlook as challenging in 2010. Consumers will likely remain highly discriminate spenders, while businesses will tread cautiously with respect to investments and hiring. There is a silver lining in this scenario — the upside is an improved likelihood of sustaining today's level of high profitability. As investors in companies, this is what matters to us most.

This begs the question of whether the market's sharp advance already reflects this high level of profitability? There are growing voices stating that it is, and that as a result the market will find it difficult to advance without further improvement in growth prospects. While we concede there is some truth to this, it is not cause for concern.

Looking back at last year's rally, the market's rebound appears not to reflect the profitability either, but rather that a majority of companies within the market were priced to fail. The fact that they didn't, resulted in a sharp turn in their valuations. Today many of those companies that posted the most spectacular gains in 2009 look susceptible to either giving back a portion of their gains, or merely treading water. High quality companies, however, appear quite different.

On one account, many high quality companies barely participated in last year's recovery, though they improved the most in terms of "real value" — the actual value of the business. The result is that they appear even more attractive as long-term client holdings. Fortunately, we at Quantum are high-quality investors, long recognizing that while the market may be perfectly efficient, it is not always perfectly rational. This being said, we see the potential for this year's "market" to be more challenging than during the last nine months, but ample opportunities to differentiate ourselves from the market of investors by holding and seeking out the highest quality, most consistent businesses at attractive values.

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By Howard B. Aschwald, CFA

Wow! What a year.
After a dreadful plunge for the first two months of the year, the market staged a spectacular recovery to finish in solidly positive territory. From the market lows around March 9th, the S&P 500 gained nearly 65%, one of the steepest recoveries on record.

Much credit can be given to the Federal Reserve for taking actions that restored general confidence in the financial system. In particular, the mammoth purchase of mortgage securities by the Federal Reserve and virtually free interest rates, allowed the recovery process to begin. Once the panic phase and intense uncertainty diminished,investors reconciled themselves to the new reality of a steep recession. While a recession may be painful, investors know the basic story line and can anticipate better times economically.

As the year progressed, leading economic indicators started to rise, consumer confidence improved and corporate sales and profits increased. Unfortunately, employment continued to worsen; however, from the market's viewpoint, unemployment is a lagging indicator and does not improve until an economic recovery is well underway. Since rising unemployment was expected, the market discounted the seemingly bad news and continued to advance throughout the year.

The 4th quarter in brief.
The rally continued, the economy showed definite signs of improvement, and the biggest health care reform in decades inched toward reality. Stocks did well, with the S&P 500 rising 5.49% for the quarter. A wave of buyers rushing to take advantage of federal credits helped the real estate market. World economies were growing healthier. By the year's end, even practitioners of the dismal science of economics were largely thinking positive.

Domestic economic health.
Let's look back at some key economic indicators during the quarter. Personal spending rose 0.6% in October and 0.5% in November; personal incomes rose 0.3% for October and 0.4% for November. The jobless rate climbed to 10.2% for October, then declined to 10.0% with only 11,000 jobs lost in November, the tiniest payroll decline since the start of the recession.

The Consumer Price Index rose 0.3% in October and advanced 0.4% for November. The Producer Price Index rose 1.8% in November due to a 6.9% month-over-month jump in the price of energy goods.

The Federal Reserve kept interest rates at record lows while dropping occasional hints that rates might necessarily rise in coming quarters. After much contention, the House and Senate passed differing versions of health care reform legislation, with the bills yet to be reconciled as 2009 drew to a close.

Major indexes.
Q4 2009 was not as amazing for the market as the preceding quarter, but it was good just the same. The fourth quarter also brought a big descent in the CBOE VIX (the "fear index" fell 14.92%). With a strong concluding quarter, the Dow gained 59.28% from the March 9 close to the end of the year. The S&P 500 and NASDAQ respectively gained 64.83% and 78.87% in the same time frame.

Global economic health. The data suggested a global recovery in full swing, with Asia's economies leading the way. The IMF and the OECD respectively predict 3.1% and 3.4% growth for the global economy in 2010, with the bulk of emerging and developing economies heating up to 5% growth or better. China's economy grew 9.0% in 3Q 2009 as India's economy grew 7.9%.

With much of the developing world rebounding in rapid growth and the developed country economies turning positive, 2009 ended with a much sounder economic outlook than the start of the year. While retail investor skepticism remains high with record setting amounts of cash and low risk bonds, institutional investors were quick in 2009 to embrace riskier stock and bond assets. This should auger well for 2010 and 2011 as the investing public returns to investing rather than staying in low yielding savings type assets.

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By Mike Vogel, CFA, CFP®

2010 brings a few new twists to the constantly changing world of financial planning. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is scheduled to "sunset" on January 1, 2011 as a result of the Senate rule that limits laws with a negative fiscal impact to 10 years. (Byrd rule) The EGTRRA steadily lowered the Estate and Gift tax to 45% while at the same time increased the exemption amount up to $3.5 million by 2009, then for 2010 both taxes are completely eliminated.

When Congress let the estate tax expire in 2010, they did not do anyone any favors. Estate planning attorneys are scrambling to work with the unknown questions. If congress creates a new law, will it be retroactive to January 1st? Will there be a court challenge? Will we just revert back to the old limits in 2011 as scheduled? Although no estate tax sounds great, the reality is many people who were not wealthy enough to put them in the estate tax danger zone will now be affected by the new rules.

The issue that will affect the majority of people is the loss of the automatic step-up in basis rule. Under the old rules when you inherited assets your cost basis was calculated as the fair market value on the date of death. Under the new rules the heir assumes the original cost basis of the deceased. For estates that have more than 1.3 million in appreciated assets this will be an expensive tax hit to the heirs when they sell the assets. Each estate has an exemption for the first 1.3 million dollars of gains. There is also a 3 million dollar exemption for assets inherited from a spouse. The biggest headache is the time and energy that people will have to spend tracking down all the original cost figures. It is noteworthy that the last time this carryover in basis rule was tried it was repealed retroactively because of the difficulty in administration.

Dividend and long term capital gains rates are another moving target for 2010 and 2011. The favorable 15% rate is set to go away in 2011. Should you base your investment decisions solely on this fact? No, but if you were planning to sell an asset anyway if might be valuable to get out before the end of 2010.

This year also brings back the Required Minimum Distribution (RMD). Remember, if you are over age 70½ you will need to take a withdrawal from your IRA, 401(k) or Defined Benefit Plan this year. The withdrawal amount is based on your account value as of 12/31/2009 so keep a record of that number.

Contribution limits to retirement accounts are one thing that remains unchanged from 2009 to 2010. Take advantage of the opportunity for tax deferred growth and maximize your contribution.

Wealth Transfer Idea
One idea for passing along assets to the next generation might be to take advantage of interest rates being close to their all time lows and make an Intra Family loan. For people interested in transferring wealth to their heirs, a loan is a very effective way when interest rates are low. 2009 brought U.S. treasury rates to historic lows. Before rates go back up it might make sense to consider an Intra-Family loan as a less exotic but perhaps less risky way of transferring wealth to the next generation.

The key to transferring wealth through an intra-family loan is the Applicable Federal Rate (AFR). The AFR is the rate at which the loan will be evaluated for both income and gift tax purposes. If the stated interest rate on the intra-family loan is at least the AFR there is no gift element to the transaction unless the interest is not in fact paid.

Current AFR's for January 2010 are .57% for a short term loan 1-3 years; 2.45% for a medium term loan 3-9 years; and 4.11% for a long term loan over 9 years. For example: A grandmother could lend 200,000 to her granddaughter for three years at .60%. The granddaughter then invests in a CD at 2.5% for three years. Over three years the CD earns $15,000 in interest and the granddaughter pays $3,600 in interest. The difference of $11,400 transfers exempt from both gift and generation skipping tax. If the granddaughter earns a higher return, the transfer is even greater.

Another example: Mom & Pop could lend money to their children to purchase or refinance a home at 4.25% for 30 years. This is a better rate then the children can get from a bank but it is higher than the long term AFR so there is no gift element. The wealth transfer here is in the appreciation of the home and any future income, most likely higher than 4.25%, that Mom & Pop are giving up over the life of the loan.

These are just two examples of simple ways to take advantage of low AFR's. Even greater wealth can be transferred if the borrowed funds are invested in appreciating assets. These transactions are appropriate only for families with excess cash or other liquid assets. It is not advisable for older generations to risk their financial health solely for the purpose of transferring wealth to a younger generation.

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By Stephen Bradley

We are pleased to introduce the 5 new members of our team at Quantum, all with a great deal of experience and expertise in the financial services industry. These additions will increase the depth of our resources and allow us to enhance our client service efforts in order to provide you with the superior service you deserve.

The biographies of our 5 new team members are listed below:

Peter C. Sinatra
Senior Managing Partner
Pete is also a Senior Managing Partner with the Seligman companies. Pete is a member of Seligman's Investment Committee, managing traditional and private equity investments in the banking, real estate, aviation, film and asset management industries since 2004. Prior to joining Seligman, Pete held leadership positions in marketing, business development and management at Fidelity Investments and Bank of America; he started his career at Arthur Andersen & Co as a consultant in the financial services industry. Pete has served on numerous boards, most recently Sterling Bank & Trust as Non-Executive Chairman and Sentient Flight Group. He is a member of the CFA Institute, the Boston Security Analysts Society and the San Francisco Security Analysts Society. Pete received his BA in Mathematics from the College of Holy Cross.

Lyle "Skip" Bonn
Managing Director
Skip has nearly 30 years in the investment business, starting with Morgan Stanley in 1980, where he spent almost 20 years and managed over 200 million in client assets. He then spent 9 years in private practice prior to joining Quantum Capital Management. Skip has served as a keynote speaker with Charles Schwab's National retirement conference regarding ETFs in the pension and retirement planning arena. Skip was one of the early innovators of ETF lifestyle strategies and open architecture as head of 401K Retirement Solution's investment team. Skip received his BS degree in Business Administration from California Western School of Business — United States International University. He has served on the adjunct faculty at a local Bay Area college's business department and served in the United States Navy both on active and reserve duty. An avid windsurfer and sailor, Skip has three children.

Michael R. Vogel, CFA, CFP®
Managing Director
Mike has spent more than twenty years in Institutional Fixed Income, specializing in Municipal Bonds and Corporate Cash. He started his career at Paine Webber and developed his skills working for Sutro & Co., Piper Jaffray and Fidelity Capital Markets. At Quantum he is part of the Fixed Income management group and Business Development team. Mike received his BS degree in Managerial Economics from U.C. Davis. He is a Chartered Financial Analyst (CFA) and also has a Certified Financial Planner (CFP®) designation. He is a member of the CFA Institute and the Security Analysts Society of San Francisco. An ex-rugby player and a private pilot his passions include flying, boating, skiing and camping. Mike and his wife live in Corte Madera with their three sons.

Conni Brinkman
Managing Director
Conni has over thirteen years of experience in the investment management business. Prior to joining Quantum, she was a Director at Lateef Investment Management, focused on marketing and cross-selling firm expertise to Institutional, Financial Intermediary and High Net Worth prospects and consulting firms. Conni spent over seven years at RCM Capital Management in San Francisco working with the firm's Corporate, Public, Endowment, Foundation, and Financial Intermediary clients. Prior to moving to the west coast, she worked for both Lazard Asset Management and Sanford C. Bernstein & Co. Inc in New York in client service and marketing roles. Conni received her BS in Finance from Boston College and holds Series 7 and Series 63 securities licenses. She currently resides in Burlingame and enjoys running, yoga, skiing and travel.

Brett Meyer, CFA
Managing Director
Prior to joining Quantum, Brett held positions in the Institutional Consulting Group, Plan Sponsor Consulting Group and the Independent Advisor Group with Callan Associates since 1998. In his most recent role with Callan Associates, Brett served as a director of research for the Independent Adviser Group, overseeing an open architecture investment manager platform consisting of over 200 unique products. In addition to his investment research responsibilities, Brett also served in a client service capacity for collection of RIA's multi-family offices, and large financial intermediaries. Brett is a Chartered Financial Analyst (CFA charter holder) and received his BA in Business Administration & Sports Management from Principia College, where he was named an All-American Tennis player.

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