Karp Capital Management Focus

2nd Quarter Report

Written by Peter C. Karp
July, 2015

Money, Politics and Beyond

Eurozone and the U.S. Economy

The underlying strength of the global economy suggests that the current hiccup in the bull market reflects temporary uncertainties rather than weak economic or corporate fundamentals. The ongoing Greek crisis, the Puerto Rico debt default, lower oil prices, and speculation over the Federal Reserve’s action have all contributed to the market’s malaise. At the end of the second quarter, markets around the world experienced increased volatility as Greece missed a €1.5 billion payment to the IMF and imposed limits on bank withdrawals. The coming weeks will prove critical in the ongoing Greek drama. At home, mixed economic data continued to weigh on investor sentiment. June’s employment report marked the 14th month out of 16 in which the economy added 200,000+ jobs. In addition, the unemployment rate fell to 5.3%, the lowest since April 2008. Gains were offset by flat wages while the labor force participation rate dropped to its lowest level since October 1977. Meanwhile, the U.S. auto industry is on pace for its strongest sales year since 2005. A general lack of conviction marked the first half of 2015 as the Puerto Rico debt default, the dramatic slowdown in China’s economy and the timing of the Fed’s interest rate increase seemed to preoccupy investors. The S&P 500 Index was essentially flat while the Dow Jones Industrial Average eked out a small gain. Historically low interest rates and bond sales have fueled stock buybacks and mergers and acquisitions in corporate America. Consolidation in the healthcare sector has escalated with Aetna’s pending purchase of Humana for $34 billion. Also, Anthem is expected to reach a deal to purchase Cigna in the near future. In fact, mergers and acquisitions activity in the U.S. exceeded $1.2 trillion during the first six months of the year, an all-time record. We believe the rising appetite for deals points to confidence in the overall economy and can serve as catalysts for a stronger Q3 and Q4 in the markets. In this issue of Karp Capital Focus, we will take a look at how the improving economy is affecting the markets, how the Eurozone influences our outlook and the opportunities presented by each.

In This Issue:

Money, Politics and Beyond

Market Performance

The Fed – A Conundrum

China – In For a Rough Landing

Do Rising Interest Rates Affect Stocks?

Has the Bull Market Run its Course?

Will the Eurozone Kick Greece to the Curb?

What is an Investor to do?

Bond Pricing 101

Building on Growth

Loan Sweet Loan

Much of America is Getting Richer

The Normal Ebb and Flow of the Market

Identity Theft & Fraud

Historic Reform

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Market Performance

Here are the performance numbers for the major indices as of 6/30/2015:

Latest
1 Month

Latest
3 Months
2015
% Change
The
Close
Dow Jones Industrials
-2.17%
-0.88%
1.14%
17,619.51
Standard & Poor’s 500
-2.10%
-0.23%
0.20%
2,063.11
NASDAQ Composite
-1.64%
1.75%
5.30%
4,986.87
Russell 2000
0.75%
0.42%
4.75%
1,253.95
MSCI EAFE
-2.98%
-0.37%
3.81%
1,842.46
Long Term Treasury Bonds
-3.97%
-2.66%
-0.46%
Gold
-1.71%
-1.35%
-2.36%
After several years of double-digit returns, the S&P 500 is lagging, effected by lower oil prices and a stronger U.S. dollar. U.S. small caps have benefitted from their domestic orientation, returning 4.8%. Outside the U.S., both emerging and developed equity markets have regained some ground this year, rising 3.1% and 5.9%, respectively. Commodities continue to struggle, falling 1.6% in the first half of 2015. In June the VIX (volatility index) jumped 31.7% to its highest levels since February. This year, healthcare (+8.7%) and discretionary (+6.0%) lead, while utilities (-12.3%) and energy (-6.1%) have lagged. Low quality (+1.6%) still led high quality (-0.3%) in the first half of 2015. Small cap index owes its gains to biotech which is up over 30% YTD.
Sources: Thomson Reuters, WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML



The Fed – A Conundrum

Despite the uncertainties around Europe's prospects and mixed U.S. economic data, we still believe the Fed raising interest rates in 2015 is a possibility, putting the era of zero interest rates in the rear view mirror. The Fed’s only reluctance to raise key interest rates would be because inflation hasn’t yet built up any meaningful momentum. The Labor Department announced that the Consumer Price Index (CPI) rose 0.4% in May, the largest monthly gain in more than two years. Economists were expecting the CPI to rise 0.5%, so May inflation was actually less than expected. Gasoline prices rose 10.4% in May and were largely responsible for the jump in the overall CPI. A possible concern for the Fed is that hourly wages declined 0.1% in May. Excluding food and energy, the core CPI rose only 0.1% in May. In the past 12 months the CPI is unchanged, so there is no evidence of an inflation threat. The Federal Open Markets Committee (FOMC) said that economic activity has been "expanding moderately" after a tough winter, and job gains have "picked up”. Markets rallied on expectations that the Fed may delay raising interest rates. The FOMC is also more focused than usual on global developments in Greece, the weak economic recovery in Europe and the U.S. dollar/global currency movements. However, Fed Chair Janet Yellen noted that the path of future rate hikes is more important than the timing of the first rate hike. On this point, the Fed reiterated that future interest rate increases will be undertaken only if the U.S. and global economies are healthy enough to support higher borrowing costs. The impact of cheap oil and a strong dollar is a positive for the U.S. economy. Low oil prices benefit consumers, especially if prices stabilize at the current level. Additionally, a strong dollar has been positively correlated with GDP growth over the long term and is a tailwind for the economy. Payrolls have returned to their pre-winter pace, retail sales are rebounding—with auto sales hitting a nine-year high—and a variety of housing indicators have surged.

China – In For a Rough Landing

China and the MarketThe recent volatility in the stock market in China and Hong Kong continues to intensify to the downside. Trading on margin is at a record-breaking high and unwinding that leverage is at the heart of the market meltdown. New regulations are focused on reducing the natural functions of a healthy market. The Peoples bank of China has kept short term liquidity flowing through the equity market and there has been any acceleration in the pace of longer-term monetary easing. The focus should be on building confidence in the markets through transparency. There is no guarantee of a happy ending, and we suspect it will still require a more meaningful monetary policy by the PBOC to stop the bleeding. Our portfolios do not contain direct emerging market or China exposure. We’ve been positioning our portfolios with an eye toward minimizing risk since the beginning of the year.

Do Rising Interest Rates Affect Stocks?

Are rising interest rates bad for stocks? It might seem so. After all, higher rates mean higher borrowing costs for corporations. However, history suggests otherwise. Since 1998, changes in bond yields and equity performance have been positively correlated, (i.e. equities and bond yields have risen together). There are a few theories to justify this trend. Typically, a rise in inflation expectations is positive for equities (with equities being an inflation hedge) when inflation expectations rise from sub 2% to over 2%. Keep in mind, many companies pass inflation on to their customers and receive it right back for their investors. Rising rates are actually a sign of good things to come. Some of the best and most consistent average returns have occurred when interest rates have risen from very low levels – as is currently the case. From our perspective, this means that the bond market is correctly anticipating future economic growth and staying ahead of inflation – things that typically benefit stock prices. That all sounds good in theory, but what actually happened the last time the Fed raised rates? Starting in June of 2004 and ending in August 2006, short-term rates were hiked 17 times from a starting point of 1% to a peak of 5.25%. Over this two-plus year period, GDP grew steadily as did stock prices.

Has the Bull Market Run its Course?

Investors are concerned about what will happen when the Fed raises interest rates. We are nearly 6 years into the recovery/expansion cycle and the Fed hasn’t raised rates. No bull market or economic cycle ends on its own. It ends in a liquidity crunch when the Fed tightens short term interest rates, dramatically inverting the yield curve (driving short term rates higher than long term rates). Ben Bernanke raised rates in June 2006, but the market didn’t collapse for another 12 to 18 months. Prior to that, Alan Greenspan’s last rate hike was in May 2000, six months before the dot-com crash unfolded. The Fed hiked rates in May 1989, but the bull market continued well into 1990. The U.S. has never been brought into a recession by another country, so in spite of the world’s woes we don’t foresee a tailspin in domestic markets. The odds of a steep recession in the near term appear to be zero. Consumers, the mainstay of the economy are bullish on the future. Keep in mind, 70% of Gross Domestic Product (GDP) is tied to consumer spending.

Will the Eurozone Kick Greece to the Curb?

Eurozone and GreeceEuropean stocks continue to struggle on higher volatility as investor sentiment is increasingly driven by the tenuous situation in Greece. With a 1.5 billion euro payment to the International Monetary Fund past due and funds flowing out of the Greek banking system, the window for reaching a resolution has temporarily closed. Progress has been made on certain issues, but differences remain on Greek pension reform—a critical topic given that the pension system represents an astounding 16% of Greece's gross domestic product. The fact is, Greece's troubles are hardly new information for the markets, but we’re aware of how unpredictable the reaction to a Greek default is. The majority of Greeks have consistently maintained that they want to remain in the Eurozone even when they elected a socialist offshoot to power. Syriza, the ruling party in Greece, has maintained that cuts to pensions and benefits have put the economy in a death spiral, resulting in a five-year recession. Just as things had begun to stabilize, Syriza's own policies have resulted in a gigantic bank run, which has crippled the financial system and caused Greece's economic statistics to deteriorate again. Clients should not equate the imposition of spending controls with a Greek exit from the euro. We continue to expect that a solution, albeit a temporary one, will be found. In addition, by providing liquidity to the broader Eurozone (in the form of its monthly bond-buying program), the European Central Bank (ECB) is helping to limit the scale and duration of any contagion related to events in Greece. Greek risk is now largely isolated from the European financial system. Most Greek debt is held by other European governments, the IMF and the ECB. Recently, a different dynamic has emerged where a weaker euro is seen as beneficial for European stocks. Overall, Greece owes 323 billion euros to all its creditors. However, according to the IMF, missing a payment does not constitute a default, rather, the loan is delinquent. With the IMF saying that missing a substantial payment is not a default and with the ECB still pumping money into Greece's banks, they have bent over backwards to rescue Greece. The new twist in the Greek saga points toward heightened uncertainty in the days ahead, an environment that is supportive of a strong dollar.

What is an Investor to do?

Greek RuinsThe U.S. equity market has been stuck in a fairly narrow trading range since the beginning of the year. Investor sentiment was dampened by the debt crisis in Greece and Puerto Rico. The recent backup in bond yields has improved the appeal of Treasuries and we are recommending long duration positions from a tactical perspective. Renewed weakness in oil prices has given us an opportunity to upgrade the quality of our energy holdings. The benign interest rate environment suggests that the path of least resistance for stock prices remains upward. Poor valuations are not an obstacle for stock and bond markets to perform reasonably well over the next 6 months. The S&P 500 Index and the NASDAQ were able to grind out yet another all-time high during the first half of 2015. We are adding monies to our favorite sectors during any market pullbacks. We favor technology and other cyclical companies, which tend to hold up better during periods of rising interest rates. At the same time, we are selling traditional yield proxies, including some utilities and REITs as they remain expensive and vulnerable to a rise in interest rates. We continue to prefer healthcare, which historically has been less sensitive to rising rates than other traditionally defensive sectors. Internationally, we are adding exposure to the Japanese markets but choose to stay away from the Chinese stock market. Europe will do its best to contain the Greek fallout both financially and politically. With low liquidity and political turmoil, we think it's time to play defense and hold back cash before investing more money in Europe.

Bond Pricing 101

Why would you pay more for a bond (a premium) than what the bond was issued for? Undoubtedly, many investors believe that if they pay a premium for a bond, their total return will be lower. This is not necessarily true. Investors who want a more accurate representation of their total return should first consider the bond’s yield to maturity (YTM), the annual return if it is held until maturity. Bonds selling at a discount cost less than the premium bond, but you must remember that the discount bond’s coupon payments are lower, resulting in less net cash flow and a lower annual total return to the investor. While helpful, the YTM is not always the final word when evaluating an investor’s total return. Bonds are sometimes callable, an option giving the issuer the right to redeem the bond at some point before maturity. While buying a bond priced at a discount seems at first glance to be more attractive than one trading at a premium, there can be real benefits to premium bonds. Premium bonds generally have less price sensitivity to interest rate changes than discount bonds, since more of their cash flow is received in higher coupon payments and they have a lower duration, so they are more defensive if rates rise. Currently we are adding municipal bonds to our clients’ taxable portfolios. There are many municipalities that have turned the corner and credit worthiness is improving. Historically, muni bonds have a very low default rate versus corporate and other income investments. In addition, most of our clients are in a high tax bracket and receiving double tax free income is an appropriate complement to dividend and other interest income. Give us a call to learn how tax free income fits into your portfolio.

Building on Growth

Housing MarketThe Census Bureau estimate of new home sales for May comfortably beat expectations and has broken out to a new recovery high for the strongest reading since February 2008. Mortgage availability is improving and it is now clear that the spring selling season marked the start of the second leg of recovery for the new-home market. Housing is getting a boost from the improving job market. With the unemployment rate roughly 2% lower than it was 2 years ago, the domestic labor market is substantially stronger. Perhaps most important is the sense that a key psychological corner has been turned. Buying a home is an emotional decision as well as an economic one. Buying pressure is reaching critical mass in a number of geographic markets and will be reflected in mortgage originations going forward. We are still only operating at around 50% of normal activity in new home construction and therefore it’s hard to overstate the potential for recovery going forward. With inventory very tight, at just 4.5 months, we have to expect price gains to accelerate; homebuilders have been one of our top investment themes over the last 8 months.

Loan Sweet Loan

This year we launched our redesigned website. KarpCapital.com includes information on the many services we offer to help build a comprehensive plan for your financial future. One service that often gets overlooked is home loans. Real estate comprises a significant portion of an investor’s assets and it’s important to consider both sides of your balance sheet, assets and liabilities. It is important to understand how your home loan fits into your financial picture. Rates are now coming off of historic lows and the opportunity presented by central bank stimulus is not going to last forever. This could be the time to lower your mortgage payment, take cash out for that long-awaited remodel, or even look to purchase an investment property to increase your income and diversify your portfolio. We can help you evaluate the affordability of purchasing a new home or how your country house will affect your retirement goals. We encourage you to call our office to discuss how you can leverage these low rates and build your net worth.

Much of America is Getting Richer

The Federal Reserve released its quarterly census of U.S. household wealth. Even though the stock market was flat last quarter, the net worth of Americans grew by almost 2% ($1.63 trillion) to $84.9 trillion. The Fed's report said that about two-thirds of the gains ($1.07 trillion) came from financial assets, including stocks and pension funds. Most of the rest came from gains in real estate values, which rose by $472.5 billion, according to Federal Reserve data. Net household wealth is up 50% since 2008, due mostly to a recovery in financial markets and real estate. The wealth effect tends to give households more breathing room to make bigger purchases or increase their volume of consumer spending.

The Normal Ebb and Flow of the Market

Stock performance year-to-date has been underwhelming. The U.S. equity market has been stuck in a fairly narrow trading range since the beginning of the year. Investors may be dismayed by the lack of market movement, yet we’ve seen similar patterns in recent years. In 2010, for example, as investors fretted over the European debt crisis, the S&P 500 closed the first half of the year down 7.9%. Then, following the creation of the European Financial Stability Facility, markets rallied 22% over the final six months of the year. Similarly, in 2012, when a potential unraveling of the euro preoccupied investors, the S&P 500 gained 1.6% through the beginning of June. Then, following the European Central Bank’s announcement to do “whatever it takes” to support the euro zone, markets rallied 11.6% over the remainder of the year. Now, investors remain focused on the Greek bailout negotiations and the timing of the Fed’s interest rate increase. We expect that market performance will improve as these events unfold over the coming weeks and months. The goal of our risk management is to participate in the majority of the gains of a bull market while avoiding the majority of the declines in bear markets, thus making the entire investment experience one that an investor can survive, stick with and be further ahead at the end.

Identity Theft & Fraud

Identity TheftIdentity theft affects millions of Americans each year. It can take just minutes to happen, but recovering from the financial damage and emotional toll often takes years. Victims of identity theft can face issues such as lost job opportunities, problems with securing a loan, harassment from debt collectors, or even possible arrest for crimes committed by the identity thief. Financial fraud is rising. Technology makes communication accessible and affordable across the globe, but it also means that scams, phishing and hacks often originate overseas and criminals anywhere in the world can target seniors. Technology also offers new and creative ways for criminals to act. At Karp Capital Management we are in constant contact with our clients learning about sophisticated scams and security breaches. We suggest that clients who have diminishing capacity place assets in a revocable living trust and assign a co-trustee. In that way, two signatures are needed for any check, which can reduce the chance of an elderly person falling prey to criminals. Also, valuables should be kept in a safe, gifted or placed in a safe deposit box. Whether it is decisions regarding estate planning, long term care or housing, it’s crucial we are informed and coordinate with other professionals employed by our elderly clients. There are strategies that exist to help safeguard clients from financial fraud and abuse and to ensure their assets are protected. Call us today to review your exposure to fraud and safeguard your identity. (Click here for a checklist on how to protect yourself and your love ones)

Historic Reform

The recent decision by the United States Supreme Court declaring state marriage bans unconstitutional affirms the importance and requirement of full civil rights for same-sex couples. It also opens the door to revised estate planning for same-sex spouses. This should make estate planning easier and less costly for married couples who want to share in each other’s wealth. If your estate plan needs a fresh look, give us a call and we’ll put you in touch with legal and tax professionals who are well versed in that area.

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All of us at Karp Capital Management thank you for your continued patronage. It is a privilege to help you, your family and friends reach financial goals. Please remember that we appreciate your support and we’re flattered when you refer your family and friends. If you know someone that would enjoy our commentary on the market, please share the newsletter with them. If they would like to receive our quarterly commentary please direct them to sign up for the email edition at karpcapital.com.
If you have any questions on the analysis above, or would like to review your portfolio’s performance, please call us at 877 900 Karp. At Karp Capital, we position your financial world in the global economy.

Peter Karp
Peter C. Karp

Karp Capital Management Corporation
Registered Investment Advisor

Mailing Address: 2269 Chestnut St., #308
San Francisco, CA 94123

Office Address: 221 Caledonia St.
Sausalito, CA 94965

P: (415) 345-8185 F:(415) 869-2832
peter@karpcapital.com
karpcapital.com

If you no longer wish to receive the Karp Capital Management Focus newsletter, please contact us to be removed from our mailing list. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. All opinions and estimates herein, including forecast returns, reflect our judgment on the date of this report and are subject to change without notice. Such options and estimates, including forecast returns, involve a number of assumptions that may not prove valid. Further, investments in international markets can be affected by a host of factors, including political or social conditions, diplomatic relations, limitations or removal of funds or assets, or imposition of (or change in) exchange control or tax regulation in such markets. The past performance of securities or other investments does not necessarily indicate or predict future performance, and the value of investments. This document may not be reproduced without our written consent. Securities offered through Infinity Financial Services, member FINRA/SIPC. Karp Capital Management is not an affiliate of Infinity Financial Services.

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