Karp Capital Management Focus

3rd Quarter Report

Written by Peter C. Karp
October, 2015

The Economy is Not the Market

Troubles Come and Go

China, Greece, interest rates, and the European refugee crisis are all major headlines that have preoccupied investors in 2015. International news has eclipsed the mostly positive economic data in the U.S. bringing with it a great degree of market volatility. Trade imbalances in weak emerging markets sparked concerns while the U.S. remains an oasis amidst global turmoil. In August, the Bureau of Economic Analysis released second quarter GDP data showing an increase in growth of 3.7%, which exceeded estimates. Furthermore, the employment report for August from the Bureau of Labor Statistics showed that unemployment dropped 0.2% from July to 5.1%. The reduction seen in unemployment was due to an increase of full-time jobs, instead of part-time jobs.

Another bright spot was reported by the Census Bureau. New home sales rose 21.4% to an annual pace of 552,000 in August. The National Association of Realtors said there is a housing shortage in many areas of the country, particularly the West Coast; so further home appreciation is anticipated in the coming months. It is helpful for investors to remember that developed market growth is driven by services, rather than manufacturing, making it less exposed to the export cycle. We have noticed that service-related industries in developed markets, particularly in Europe, have grown much faster than its manufacturing counterparts in recent months. Attention is now turning back to the United States. Even with stronger U.S. economic growth, volatility will be prevalent in the fourth quarter. Investors remain nervous about China's slowing economy as the Federal Reserve continues to debate the timing of a raise in interest rates. The yield on the 10-year U.S. Treasury note varied between 2.13% and 2.24%. U.S. West Texas Intermediate crude oil futures hovered in the mid $40 dollar range most of Q3, while gold dipped below $1,100 an ounce near its low for the year.

It's hard not to be a little concerned and pessimistic based on the violent swings in equity indices around the world. Misinformation and a lack of investment strategy can lead to emotional decisions and result in missed opportunities to protect or build wealth. There are reasons for the volatility but that does not mean we take our ball and go home. Currently we are in the middle of an information vacuum until third quarter earnings are disseminated later this month. During this lull in information, we will be repositioning portfolios to reduce volatility and take advantage of growth in our focus sectors for the end of 2015 and into early 2016. In this installment of Karp Capital Financial Focus we will build a case against doom and gloom. Remember, as Warren Buffet said... "the stock market was invented to move money from those who are impatient to those who are patient".

In This Issue:

The Economy is Not the Market

Market Performance

Janet Yellen and Hamlet have a lot in Common

Where is the Beef?

Politics Front and Center

A Shock

Doing the Right Thing

Now is the time for a Charitable Trust

The Taxman Cometh

Why Pay More Taxes than Necessary?

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Market Performance

Here are the performance numbers for the major indices as of 9/30/2015:

Latest
1 Month

Latest
3 Months
Year to
Date
The
Close
Dow Jones Industrials
-1.47%
-7.58%
-8.63%
16,284.70
Standard & Poor’s 500
-2.64%
-6.94%
-6.74%
1,920.03
NASDAQ Composite
-3.27%
-7.35%
-2.45%
4,620.16
Russell 2000
-4.91%
-11.92%
-7.73%
5,243.24
MSCI EAFE
-4.75%
-8.93%
-0.56%
383.80
Long Term Treasury Bonds
1.47%
5.28%
-0.05%
Gold
-1.85%
-4.87%
-7.11%
1,114.47
VIX (Volatility Index)
-13.82%
34.39%
27.60%
Most asset classes declined in Q3 2015. The S&P 500 was down over 6% for the three months ending September 30th. This was the worst quarterly decline since Q3 2011. Falling interest rates helped high dividend yielding utilities outperform other sectors for Q3 (+4.44%) the only positive U.S. sector. Commodities fell 14% in the wake of weaker than expected Chinese data. Energy (-18.1%) and materials (-17.3%) underperformed along with the unwinding of biotechs (-14.1%). Discretionary is the best performing sector with the only positive return (2.9%).
Sources : Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML, Ned Davis Research



Janet Yellen and Hamlet have a lot in Common

China MeltdownTo hike, or not to hike? That is the question that must keep Janet Yellen up at night. The Federal Reserve's policies and the implementation of those policies have been shown to create bubbles, which tend to pop spectacularly, resulting in the Fed scrambling to reflate the busted-bubble economies. The Federal Open Markets Committee (FOMC) decided to maintain its policy on interest rates during its last meeting; this came after months of rhetoric from the Fed indicating its dual mandate of maximum employment and stable prices being met. Instead of raising rates, the FOMC decided to hold off. We have said the Fed should have raised interest rates at the end of 2014. While rates remain the same, we will continue to alert clients on the continuing volatility in the markets. In fact, it is the Federal Reserve and our politicians in Washington who are holding back economic growth. If the Fed was on the right path, keeping interest rates the same should not have confused the markets leading to a sell off. In the past, accelerating economic growth and a tightening labor market would be grounds for raising interest rates. However, the FOMC's projections for the federal funds rate at the end of 2016 are sinking with the unemployment rate. The counterintuitive relationship between the two exists because the Fed is weighing heavily on international developments (e.g. the strong U.S. dollar and turbulent global markets) in its assessment of U.S. economic strength. This begs the question: Does the Fed want to make this precarious global economic situation even more precarious with a premature rate hike? Due to the lack of transparency from China, we are seeing repercussions in the markets of its trade partners in Asia, Latin America, and Europe. Investors are starting to wonder, what is the Fed seeing that I don't? Investors are confused and the Fed is not clearly communicating its intentions. As long as the Fed is inconsistent in the data points that drive policy, market volatility will increase, economic growth will atrophy which will drive us to invest defensively. Though the market seemed to be pricing in another few months of lower-for-longer, most Wall Street economists suggest waiting for the next job report before drawing any conclusion. September payrolls rose only 142K, well below the consensus. The unemployment rate was unchanged at 5.1%, in line with the consensus. Against the backdrop of accelerating real consumption, it's hard to see what's driving the disconnect between the economy and the data. It would be a huge surprise if the Fed were to raise rates in October. The two employment reports due before the Fed meets in December likely won't offer the clarity the markets and the FOMC need. The only explanation for the lack of wage growth is that employers' perceptions of the quality of the pool of available labor is the real problem, not shrinking demand for labor. This is a real road block for future economic growth in the U.S. We will continue to invest in fundamentally sound companies given our sector focus and tune out the noise. Quality is key in this uncertain monetary policy environment. A reprieve might occur as third quarter earnings reporting season starts prior to October's FOMC meeting. Investors may increasingly turn their attention to management commentaries and outlooks for insight into the economy and market direction. The big lesson: cheap money alone can't solve the world's economic ills.

Where is the Beef?

Economy ShrinkAsset allocation has become increasingly tricky. Forward indicators of global trade are pointing to a slowdown in activity. Investors, instead of jumping back into the market based on expectations of continued strength in the economy and corporate earnings over the year ahead, are hanging on every word coming out of the Federal Reserve. In the environment of uncertain monetary policy, global concerns, low to no inflation, and low U.S. labor force participation rate we are focused on fundamentally strong sectors, stocks and managing risk.

Two sectors we favor are homebuilding and regional banking. The decision by the Fed to keep the zero interest rate policy (ZIRP) in effect is welcome by home buyers and consumers. Builder confidence in the real estate market for single-family homes rose in September to the highest level in nearly ten years. As for loans on new or existing homes, the FRB's Flow of Funds report for Q2, 2015 showed the largest increase in U.S. mortgage debt outstanding since Q1, 2008 when numbers peaked. This strikes us as a catalyst for the domestic housing market, since it is obviously much easier to support an increase in sales volume and prices with a growing pool of financing. It also confirms some of the loan officer surveys that have suggested that mortgage lending standards are finally loosening at the same time that a stronger labor market increases the pool of willing and able borrowers.

The latest dip in lending interest rates might encourage borrowers to act before it's too late. The act of buying a home also creates value. New home owners employ carpenters, landscapers and other contractors resulting in an increase in GDP of $1.34 to $1.62 for every dollar spent on housing. Homebuilding has a positive effect on money velocity, or the rate at which money is exchanged from one transaction to another. We continue to add to the regional banking sector as lending rates pull back. Banks continue to do more with less, as evidenced by the surge in loans and the relentless reduction in headcount. In addition, regional banks are still enjoying robust credit quality. Loan loss reserves are climbing steadily compared with non-performing loans, as the latter are falling to new cyclical lows. This should provide increased protection against any uptick in bad loans and an earnings and valuation re-rating in the S&P Banks Index.

We continue to steer clear of commodities and emerging markets for the time being. An interest rate hike would cause the U.S. dollar to strengthen, which in turn would put additional downward pressure on commodities and commodity-exporting countries. Portfolio performance is determined not only by what's purchased, but also by what we do not buy/own. This means not owning broad market indices like the S&P 500 ETF. Our focus on fundamentally strong sectors helps our relative performance to the broader markets as volatility rises and investors lack conviction.

Politics Front and Center

When John Boehner recently announced he'd be stepping down as Republican House Speaker, attention quickly turned to who would be his successor. As of now, that remains uncertain as various coalitions maneuver for the Speaker of their choice in a divided house. As it relates to the markets, the most imminent catalyst coming out of Washington is likely to occur in mid-December. While Speaker Boehner's resignation has paved the way for the passing of continuing resolution to keep the government funded, the resolution will expire around December 11th. While that is noted as the time that the U.S. government will have surpassed the debt ceiling, the Treasury has technically already surpassed the debt ceiling and is using so-called extraordinary measures to fund the government. By mid-December, the Treasury will have to go back to Congress to extend the debt ceiling. In addition, news headlines will compete to cover the decision on who the new speaker will be. Attention will be focused on how each candidate will affect the chances of passing a budget. Ultimately, however the decision may go, leadership is still divided as the dynamics of the house remains the same. Republicans will continue to control both Chambers of Congress while President Obama will oppose any drastic changes to the current policies. House Speaker John Boehner's announced resignation adds another element of uncertainty in the markets. Our attention will continue to focus on end of the year positioning of portfolios as companies release third quarter earnings.

A Shock

VW and EuropeThe German stock market initially took an 8% hit, due to a 23% plunge in Volkswagen's stock, after the Environmental Protection Agency (EPA) and the California Air Resources Board (CARB) said they are gearing up to fine VW for software that allowed its clean diesel vehicles to pass emission tests. In response, Volkswagen has (1) admitted guilt, (2) apologized to its customers, (3) banned the sale of additional clean diesel vehicles in the U.S. and (4) replaced former CEO Martin Winterkorn with Mattias Mueller from Porsche. The biggest fine ever levied against an auto manufacturer was $1.2 billion assessed against Toyota for sudden acceleration claims that led to five deaths. It is widely anticipated that Volkswagen will face an even bigger fine from multiple government agencies around the world due to the admission of guilt. Volkswagen's admission of falsified emission tests stunned the automotive industry; shares of auto manufacturers, suppliers and retailers declined in reaction. The fallout may be somewhat limited as the specific diesel models account for less than 1% of the U.S. market. In addition, most suppliers and retailers may be only minimally impacted as other car makers would likely benefit from any loss of Volkswagen sales. This comes as an untimely blow to the German economy. It is important to note that the auto industry creates many jobs in various industries and the actions of a single company will have wide spread impact on a country's economy.

Doing the Right Thing

In the course of onboarding new clients, we've uncovered some seemingly simple, but ultimately major red flags. Many investors believe their will or trust will take care of everything and simplify the estate of the deceased. While this is mostly true, the exception lies in the selection of a beneficiary on an IRA account. Listing a trust instead of a spouse or other person as the beneficiary of an IRA can create a complicated and expensive tax bill, as well as the possible delay of going through probate if the deceased does not have a trust. However, by naming a spouse or other person as the primary beneficiary, your heir can take advantage of a beneficiary rollover. Additionally, listing contingent beneficiaries (e.g. children, grandchildren) can help reduce further estate planning burdens while setting up your second generation heirs to take advantage of a stretch IRA. At Karp Capital Management it is our job to help you distinguish what information is accurate and what strategies are truly in your best interest. Please call us to review planning strategies.

Now is the time for a Charitable Trust

This might be the right time to establish a charitable trust if you're dealing with complex estate and transfer tax issues. Charitable trusts often come in different flavors. The current low interest rate environment is particularly favorable to charitable lead trusts which are ideal for high-net-worth individuals trying to reduce their estate tax liability. Charitable lead trusts allow donors to gift property or other assets to the trust while income generated by those assets are distributed to charity. Charitable lead trusts are further distinguished as grantor reversionary trusts or non-reversionary trusts. In a grantor reversionary trust, any remaining assets go back to the donor, while non-reversionary trusts are a very good way to leave heirs, income producing assets that are likely to appreciate. Another flavor of a charitable trust is a charitable remainder trust which comes with more restrictions than lead trusts and are more widely used. It's a great tool for getting those assets handed down to future generations while reducing gift taxes. These strategies are complex and you need to assemble the right team of advisors, including your CPA, estate planning attorney along with Karp Capital Management. If you need to assemble a team, please call us and we'll give you the appropriate referrals and guidance on a succession plan.

The Taxman Cometh

When too many people make use of tax loopholes and shortcuts, the government moves quickly to close the loop. A commonly used loophole once created by Congress is the back-door Roth IRA conversion which circumnavigates the income restrictions of a Roth IRA by converting a traditional IRA into a Roth IRA. High income individuals, phased-out from contributing after-tax money into a Roth IRA, take advantage by directly funding a traditional IRA with nondeductible contributions and converting the IRA to a Roth shortly after. Although a Roth conversion can trigger taxes, if there is no pre-tax money in the IRA then this strategy becomes tax-less. President Obama's 2016 budget proposal aims to close this loophole by limiting Roth conversions to pre-tax money only. Due to congressional gridlock, these changes may not be in effect until the next administration and with retroactive tax change being unlikely, the current window of opportunity, although still open, is rapidly closing.

A second strategy to defer taxes and grow principle uses a stretch IRA. Wealthy families pass money to heirs in Roth IRAs by converting traditional IRAs to Roth before the inheritance. The heirs can take tax-free distributions from the Roth IRA regardless of their tax bracket. As a result, recent tax-related bills include a law requiring non-spouse beneficiaries to start withdrawing money within five years. This new law greatly limits who can take advantage of stretch IRAs but does not remove it completely.

In addition to IRA strategies there are aggressive strategies for claiming Social Security benefits. The Obama budget proposes to eliminate these aggressive strategies used by married couples, which most likely includes "file and suspend" and "claim now, claim more later". "File and suspend" allows an individual who is full retirement age to apply for Social Security while simultaneously suspending the application. The act of filing gives the spouse the opportunity to sign up for spousal benefit, while the act of suspending allows the benefit to continue to grow as the spouse claims the benefit. "Claim now, claim more later" is a strategy for one spouse to increase the growth of the benefit by claiming spousal benefit at 66 or full retirement age, and switching back to their own benefit when it is maxed out at age 70. Now is the time to map out your retirement income strategy. Please give us a call if you have comments or questions.

Why Pay More Taxes than Necessary?

IRS and Where the Sun Don't ShineThe purpose of an employer starting and maintaining a retirement plan is to help employees save for retirement and reduce the tax burden for the employer. Careful plan design can reduce employer costs that result from unnecessary contributions, inefficient use of plan features, and taxable refunds to those who are highly compensated while simultaneously offering more of a benefit to lower paid staff. That's why it's important for employers to have a knowledgeable retirement plan advisor help them navigate the different types of retirement plans and plan features. Plan sponsors can help employees make contributions well beyond the 401(k) annual deferral limits of $53,000 for 2015. It can put more money in the pockets of highly compensated employees and less money in the pockets of government. Many professional service firms, such as law firms, have made use of Karp Capital's retirement plan consulting in tandem with a safe harbor 401(k) plan. These plans do not maintain hypothetical individual employee account balances like the traditional defined benefit plans. In addition, the balances are protected from creditors and are portable like 401(k) profit sharing plans. Typically they're more flexible than the old defined benefit plan with less demand for required contributions. Plans need to be in place by the end of the year. Do not wait, call us for a consultation to see if this strategy is right for you and your business.

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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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