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By Mat Johnson Following a lackluster equity market in the first quarter, the U.S. equity market has perked up, with the S&P 500 up 6.2% at this year's halfway point. These year-to-date gains were largely the result of April's 4.2% increase, the remainder realized in the first few weeks of May. Since late May however, equity markets have seesawed, owing to renewed uncertainty over economic growth, rising interest rates, higher energy prices and the continuing housing market slump. For a fleeting moment, there was even concern over yet another sharp sell-off in Chinese equities, though given the 130% gain this year and the fact that foreign investors cannot invest in this market, sympathy ran thin this time around. Underlying the positive performance in U.S. equities was a solid first quarter earnings season, and continued private equity takeouts of public companies. This latter aspect even led to the "Merger Monday" performance phenomenon, as the takeover announcements largely occurred over the weekends.  Another factor aiding equity market performance has been a continued moderation of inflation. While this has led to some expectation that the Fed might ease rates sooner rather than later, particularly given the weak GDP growth rate of just 0.7% in the first quarter, stronger economic data of late has removed expectations for any imminent cut in rates. Current expectations for second quarter GDP are now approaching 4%, and with this equities have had to unwind not only the impact of no interest rate cut at the Fed, but higher market interest rates as well.
In our view, it has been interest rate volatility that has been the largest contributor to recent stock market volatility. We entered the quarter with the benchmark 10-year Treasury yield at roughly 4.65%. Beginning in mid-May, yields then rose for five consecutive weeks, reaching a peak of 5.25%, before settling back toward current levels of 5.05%. The coincident reaction of equities was increased volatility and a modest decline in the major market equity indices. The reason behind the increase in yields continues to be debated. On one hand, there are those who feel that the upturn in market interest rates is due to the Fed not being likely to lower rates, or possibly even increasing rates at some point. On the other hand, there are those that see the higher yields as pricing in greater economic strength, resulting in bond yields needing to reflect lower demand for the low yields prevailing at the end of the first quarter. We fall into the second camp. What we have seen throughout the second quarter is a modest pickup in economic data, following a subdued pace in the first quarter. While under our view higher rates still impact equities adversely via lower market valuations, it also suggests that should economic activity be improving, companies may in fact grow more strongly than previously anticipated, thereby offsetting the valuation impact. As we look forward to the third quarter, not a lot has truly changed on the economic front. The principal drags on economic activity continue to be moderating consumer spending, the result of higher interest rates and energy prices, and a continued decline in residential real estate investment. Important to remember however, is that both consumer spending and residential investment have been "correcting" from above average levels for some time as a result of exceptionally low interest rates in years past. While there continues to be heightened concern over these adverse factors on broader economic activity, our view is that we are toward the tail end, and the drag on the broader economy is more likely to moderate going forward. Businesses on the other hand have begun to increase their pace of investment, albeit at a subdued pace. The importance nonetheless is that as businesses bring more resources to bear for future production; this should further reduce inflationary pressures over the longer term. A further benefit is that as businesses increase their level of investment, a sign of increased business confidence; it should also translate to higher consumer confidence as uncertainty over employment conditions continues to subside. Of course, since it is a global marketplace, key considerations for economic conditions at home are economic conditions abroad. By and large, developed economies continue to show slight improvement, and emerging economies are showing exceptional growth. This is having the impact of driving increased demand for U.S. exports, relative to U.S. imports from abroad, as evidenced by U.S. net exports becoming a positive contributor to GDP growth. In fact, U.S. exports have reached record highs in eight of the past nine months, owing to a combination of strong global growth and prolonged weakness in the U.S. dollar. All told, we see the near-term outlook and strategy being quite similar to our outlook following the first quarter, where we cited the risks of reducing equity exposure in light of fears of an economic slowdown and increasing exposure to fixed income. April's equity market performance and May's fixed income performance highlight just how costly that would have been. We continue to see solid underpinnings for the equity market. Earnings growth continues, though it is moderating. However, businesses appear more focused on investing in future growth, something that has not been evident for years. Increased business investment and moderating consumer spending should also favorably impact longer-term inflation trends, containing current market interest rates near current historically low levels. Each of these factors should support the broader equity market. Within the equity market, we continue to see large growth companies as the favored investment vehicles, principally as they have the wherewithal to determine their own growth prospects, as opposed to being reliant upon the economy to provide for their growth. Unfortunately, volatility isn't likely to go away any time soon, though volatility alone doesn't hurt the equity market performance; it merely focuses it on those companies with durable growth prospects at attractive prices. Given that growth is our focus, and wealth management is our discipline, we feel well positioned to continue delivering solid returns for our clients. Back to TopDog Bites and Comprehensive Wealth Management By Scott Whittemore  Summer is here and the stock markets are hitting new highs. While you are thinking about how to enjoy your summer, as part of our comprehensive wealth management approach, it is my job to keep you informed of ways to protect your investment portfolio from the unexpected. Maybe you pay too much in taxes or have not organized your finances to optimize efficiencies to protect yourself from legal, natural, and criminal risks. Whatever your situation may be, our team is available to make sure that your overall financial well-being is comprised of an integrated, comprehensive strategy and structure.
Then there are the unexpected events that you need to be protected from. Your dog bites a neighbor, you son plunks another person in the head with a baseball at the beach, or someone who attends a party at your house gets into an automobile accident. The right asset allocations and risk adjusted portfolios will not save you if you get sued. Thinking defensively means thinking about insurance. I have found that for many people insurance is a topic that, due to its unique terminology, is overly complex and boring. For others it is maddening because of a bad claims experience they have had with an insurance company. Insurance though, is very handy if you have the right kind of coverage when you need it. This article will focus on umbrella insurance coverage. Many people have never heard of this coverage, but they need it. According to Sue Stevens, Director of Financial Planning for Morningstar, Inc. and editor of the monthly newsletter Morningstar Practical Finance, what claim caused insurance companies to pay out more than $300 million in 2005 alone? Dog bites. She said, "In 2005, 15% of all liability claims on homeowners policies were for dog-bite injuries, 4.7 million of them, and half the victims were kids." Dog bites are an example of liability coverage that you get on your homeowners policy, but do you have enough coverage? Lawsuits are expensive these days. Most home and auto policies limit liability coverage to no more than $500,000. What does $500,000 buy these days if you are in court? Umbrella policies address these limits. Umbrella coverage gets its name because it provides coverage on top of your homeowners and auto insurance. It extends the liability coverage of those policies. First, make sure the basic home and auto policy's liability coverage is extended to its maximum limits (usually $500,000). Second, add additional coverage with the umbrella coverage. If there is a gap between what the homeowner's coverage pays for and what the umbrella policy pays for, you are on the hook for the gap. This situation is most likely to exist if you have coverage for auto and home at two different carriers and two different insurance agents. If you purchase all of these policies from the same insurance company it is usually less expensive. Cars are your largest potential risk. It is not unusual to end up in multimillion-dollar lawsuits because of an auto accident. However, cars are not your only potential risk. Other examples include: your child's baseball bat hits a fellow player in the head, a house cleaners slips on your stairs and breaks a leg, a kid is injured using your swing in the backyard, and the list goes on. Sue Stevens suggests asking yourself these questions. The more that you answer yes, the more you should think about umbrella coverage. Do you have a swimming pool? Do you have a big or excitable dog? Do you have teenage drivers? Do you regularly carpool other people's kids? Do babysitters or cleaning people work in your home? Do you ever leave your home in the care of a house sitter? Are you active in sports: golf, biking, skiing, boating, mountain climbing? Do people come to parties at your house, drink, and drive? The good news is that umbrella coverage may be one of the best values in terms of cost of coverage. $1,000,000 of coverage will probably cost between $100 and $200 per year. $5,000,000 of coverage could be less than $500. It will cover accidents at your home, in your car, slander, defamation of character, invasion of privacy, libel, and plagiarism. The more assets you have, the more you need this coverage. It does not provide protection for business or professional liability, but there are other types of policies that do. Next time you review your home and auto insurance, remember to protect those assets that you've worked so hard to accumulate. If you do have umbrella coverage, review your policy to make sure that you have enough. If you do not have it, look into to adding this coverage. You never know when something unexpected, such as a dog bite, can ruin your financial plans for the future. Back to TopInnovation By Howard Aschwald Innovation. A word used by many, with almost as many interpretations as people using the word. However, at Quantum, an assessment of innovation is a crucial ingredient in the qualitative way we analyze a company. As an investor in growth companies, we only invest in companies that we think will have higher sales and profits five years from now. The key ingredient to driving higher sales and profits is the degree to which a company has embraced innovation throughout the organization. So, what is an innovative company and why is it important? When most people think of innovation, they think of Thomas Edison and a new invention. That's true enough, but too limited. Innovation involves not only new products and services, but new ways of doing business. This last part is crucial, because the best ideas are useless if they cannot be organized, built out, and delivered to the marketplace in a more efficient manner. Yes, a revolutionary invention, (for example, a cheap, totally safe, almost instant cure for cancer) will be the proverbial better mousetrap that doesn't require much business skill in order to be successful. However, those dramatic inventions from random inventors are few and far between. The vast amount of business energy goes into preparation and superior execution. It is a process of constant improvement that touches everything in an organization to continually make it better. Those companies that are the most successful at fully integrating innovation become the industry leaders. Those that fall behind, don't last. Last year, IBM conducted a major study of innovation that included interviews with 765 CEO's of major organizations around the world. 65% of these leaders said they will have to make fundamental changes in their business models in the next two years. IBM's definition of innovation: "using new ideas or applying current thinking in fundamentally different ways to effect significant change." IBM's study found that companies that are in the upper half of using business model innovation enjoyed significant operating margin growth, while those in the upper half using products/services/markets and operational innovation have sustained their margins over time. Companies in the lower half of the innovation rankings did not perform nearly as well financially over the previous five years. From an investment viewpoint, Quantum wants to own companies in the top half of the innovation rankings. These are the superior companies that will generate better financial results in their industries over time. This also provides an extra degree of safety in that companies with a strong culture of innovation will be able to adapt, grow, and prosper in rapidly changing times. Better company financial results from sustainable innovation, when combined with our disciplined reasonable price buying strategy, will lead to superior investment results. Back to TopEmployee Spotlight: Scott Whittemore  As most of you know, we have added a new member to our team. Scott Whittemore joins Quantum with a wealth of experience in the financial services industry.
Scott began his financial career in 1980 as a financial analyst with an international petrochemical engineering company in Rome, Italy. Later he moved to Autodesk, Inc where he set up the company 401(k) plan, served as corporate treasurer, as well as taking on international management assignments in Japan, Australia, and Latin America. Prior to joining Quantum Capital Management, Scott was a financial advisor with Park Avenue Securities, where he provided comprehensive financial planning solutions for high net worth individuals. Scott is a Charter Retirement Planning Specialist and has Series 7 and 66 equity licenses. He received a BA from Claremont McKenna College. Scott is married, with a daughter, who is a junior at Tam High School and a son in 3rd grade at Edna Maguire in Mill Valley. He enjoys coaching his son's basketball and baseball teams, skiing with his family in the winter, and relaxing at the beach with his family in the summer. Scott is also an active member of Toastmasters and supports Kiddo, the Mill Valley Education foundation. Please do not hesitate to contact Scott at (415) 927-8430 or via email at swhittemore@quantumcap.com for any of your financial planning needs. Back to TopAFG Research Summit  On June 14th and 15th we sent four of our team members, Mat Johnson, Stephen Bradley Jr., Adam Breech, and Katie Salvaterra to the Applied Finance Group's (AFG) 4th Annual Research Summit at the Wynn Las Vegas. Attendees were able to take courses in a number of topics, including equity research and valuation.
Guest speakers at the conference included Aaron Brown, author of The Poker Face of Wall Street, Russell J. Lundholm, Ph.D, Professor of Accounting at the University of Michigan, and Dennis R. Capozza, Ph.D, Professor of Finance at the University of Michigan. At Quantum, we strive to continue our education and are always looking for new ways to improve our business. Back to Top
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