Karp Capital Management Focus

4th Quarter Report

Positioning Your Financial World in the Global Economy
January, 2016

Eyes Wide Open

2016 Handoff

2015 was a tragic and volatile year. We saw sovereign defaults, terrorist attacks, a mass exodus from Syria, the intentional depreciation of China’s currency, and two major corrections to the U.S. stock market. These events show just how connected we are as nations, economies and citizens. What happens on the other side of the world has an immediate impact on our lives. Some good might come from these events. China’s market is now less controlled, Europe has a larger labor force, and there is a move toward international solidarity to combat terrorism.

As 2016 begins, the markets appear to be focused on the deleterious effects of lower oil prices on the energy sector rather than on the benefit to consumers. This is a puzzling view given that consumer spending accounts for more than two-thirds of U.S. economic activity. The strength in the labor market may finally be translating to higher wages which is good for the consumer but a challenge for corporate profit margins. We believe growth and the markets will recover in 2016, aided by better data and a still-dovish Federal Reserve. The global economy has suffered from China’s slowdown and currency devaluation. Europe is undergoing quantitative easing to stimulate growth, while balancing the inflow of migrants, geopolitical tensions and insolvency in Greece. Global growth generally appears to be improving and foreign central banks are largely easing monetary policy.

Although recent volatility is beginning to temper investor enthusiasm, investors should not be discouraged because a flat year (or years) within a bull market is not uncommon and history shows us that rocky flat years are often followed by strong years. In 2016, we expect global growth to be somewhere just north of 2%. We are well positioned for future gains as the markets digest slowing growth in Asia, rising interest rates, the strong dollar and the down draft in oil prices.

In This Issue:

Eyes Wide Open

Market Performance

Fed Rate Hike

The Crystal Ball

A Barrel of Crude

The Great Migration

Credit: Bond Markets Rule the World

Investment Thesis 2016

Risk and Volatility

Changes to Social Security

TOD and Real Property – Beware

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Market Performance

Here are the performance numbers for the major indices as of 12/31/2015: (price return)

Latest
1 Month

Latest
3 Months
2014
% Change
2015
% Change
The
Close
Dow Jones Industrials
-1.66%
7.00%
7.52%
-2.23%
17,425
Standard & Poor’s 500
-1.75%
6.45%
11.39%
-0.73%
2,044
NASDAQ Composite
-1.98%
-8.38%
13.40%
5.73%
5,007
Russell 2000
-5.02%
3.59%
4.89%
-4.41%
2,823
MSCI EAFE
-1.33%
4.75%
-4.48%
-0.39%
1,716
Long Term Treasury Bonds
0.04%
-1.24%
26.34%
-1.29%
Gold
-0.18%
-4.85%
-0.19%
-11.61%
1,060
Emerging market equities and commodities both had negative returns as the dollar soared and global growth slowed. The Dow Jones Industrial Average fell 2.23%, its first annual decline since 2008. Meanwhile, the technology-heavy NASDAQ Composite gained 5.73% and the Russell 2000 Index of small companies lost 4.41%. The performance of individual sectors diverged; Consumer discretionary was the best performing sector for 2015 (+8%), technology (4.27%), and healthcare (+5%) sectors gained while energy plummeted. U.S. crude oil prices fell 30%.
Sources : Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML, U.S. Global Investors



Fed Rate Hike

The Fed AwakensFor the first time since November of 2008, the Fed decided to raise interest rates. After debating the issue for much of 2015, on December 16th, the U.S. central bank decided that the U.S economy had recovered sufficiently to handle a rate hike. Much of the indecision was related to the fear of tightening monetary policy too early, a mistake made in 1936. Seven years after the 1929 stock crash, the Fed increased the reserve requirements for banks, tightening the money supply. In combination with an increase in taxes, this slowed the recovery from the depression and launched the country into a recession.

What then, gave the Fed the courage to act? At the October Federal Open Market Committee (FOMC) meeting, when rates were at zero, the Fed wanted to see some further improvement in the labor market. As the year progressed, the payroll data for October and November showed a total increase of 509,000 employees. In addition, jobless claims and hiring intention surveys, both leading indicators for December jobs data, strongly hinted that the U.S. economy would add three-quarters of a million jobs in the fourth quarter. Strong employment data provided the Fed with the confidence to raise rates. The reality was even better than the projection, as the labor market gained nearly 300,00 new jobs in December. 2015 was the fifth consecutive year where employment grew by more than 2 million. If the Feds voted to remain dovish in December, there was the possibility we would have seen a big sell off in the capital markets as investors would have perceived the Fed’s inaction as economic weakness.

In addition to employment data, the Fed considered the detrimental effects of an oversupply of credit. When money is scarce, companies are forced to invest only in projects that will yield the most value. For the past few years, corporations have taken advantage of low interest rates and borrowed large amounts of money to spend on acquisitions and stock buybacks. The mentality was very much, if you don’t use the cheap credit, you’ll lose it.

The Crystal Ball

So what’s next when it comes to monetary policy? Historically, the Fed has been comfortable with a 0.25% bump each meeting after the initial rate increase. Based upon the FOMC minutes, it appears that the Fed intends to continue this pattern. That would push the target for fed funds up to a range of 1.25% to 1.50% this year. Is the U.S. economy strong enough to sustain an upward trend in short-term interest rates? That is the million dollar question. The Fed may choose to be dovish and keep interest rates lower for longer by taking smaller steps. However, labor markets will most likely continue to tighten with wage pressure building. This will continue to put pressure on the Fed. How will the Fed react? All eyes remain on Fed Chair Janet Yellen.

A Barrel of Crude

Riding the Crude BarrelIn 2011, a barrel of crude oil was trading north of $100. Since 2014, the price of crude has declined sharply to just over $35 a barrel. Russia continues to extract oil at a post-Soviet record high of 10.78 million barrels per day despite dropping oil prices. Some banks, such as Goldman Sachs, predict oil prices could fall to $20 per barrel as the world produces more oil than it consumes. What is causing this sharp drop in prices and how do oil prices affect the economy? For the past decade, the oil producing nations that form OPEC set predetermined maximum output limits to stem the available supply. While developing economies (e.g. China) continued to grow rapidly, the steady demand with the restrained supply pushed prices up to triple digits. Additionally, American oil companies deployed new technologies and ramped up production capabilities. Large drilling projects were approved overnight and we saw a resurgence in hydraulic fracturing (fracking) targeting oil trapped in shale. We’re seeing a glut of oil in the world markets. This shift in supply and demand has the sovereign governments of the oil producing nations worried. Their fiscal policies depend on a stable oil price, and as prices fall, they’re faced with the need to pump more oil to make up for the deficit. There are no more production limits and the world has been flooded with inexpensive oil. In the long run, this will help facilitate a market driven by supply and demand and not by the oil cartels.

The uncertainty behind future oil prices has created caution. In the long run, cheaper oil prices enhance buying power and wealth of consumers. The savings from spending less on energy will allow consumers to spend more on discretionary items. We see this as a bullish indicator for the U.S. economy for the intermediate term.

The Great Migration

Europe and RefugeesThe political and humanitarian challenges in Africa and the Middle East are likely to continue for quite some time. As conditions in countries like Syria, Libya and other war torn countries have become intolerable, their inhabitants have migrated to countries in Europe. Investors view this with mixed feelings. While it is true that the influx of potential new workers is good news for a continent with an aging labor force and a lack of GDP growth, there is no guarantee that the migrants entering Europe via the Mediterranean will not become a burden on already strained fiscal budgets. Because of this uncertainty, we have reduced our exposure to European investments and we will sit on the sideline until the region is on a path to stabilization.

Credit: Bond Markets Rule the World

The Characters of 2016There are several large, ongoing fundamental shifts in the credit markets that were overlooked by the media. As the likelihood for an interest rate hike greatly increased towards the end of November, the interest rate curve started flattening because large institutional investors started swapping their short maturity bonds for 8+ year maturities. Institutional investors want to avoid holding old, short term bonds that pay next to zero interest when new bonds with the same credit rating are being issued at a higher interest rate. As short maturation bonds sold off, their prices dropped and yields rose. Prices of short-term bonds are still trying to stabilize.

Corporate bonds in the energy and commodity sectors are also seeing volatility. Oil companies require huge initial investments of capital to start drilling projects and likewise for mining projects for commodities. To easily acquire funding, companies issue floating rate bonds which protect against interest rate movements by paying a premium on top of the current rate. This strategy works as long as the wells /mines provide strong cash flow, however, these companies are facing rate hikes along with the crash in oil prices plus stagnant demand for commodities. Credit ratings for these bonds are being downgraded as companies are evaluated for solvency. We were cautious on high yield bonds for most of last year but started purchasing the high yield ETF (HYG) in Q4 as we began seeing value in the market.

Global events in addition to the rut in oil prices continue to further strengthen the dollar. Europe is undergoing quantitative easing, the Chinese central bank cut rates six times last year, defaults in Greece, Argentina and the credit crises in Brazil has everyone looking at U.S. Treasuries. Given the tumult in the world, investors are buying up U.S. Treasuries as they provide safety and increasingly better rates and pay interest in the form of an appreciating currency. Towards the end of Q4, 2015 we added to our long term treasury position, getting in front of volatility and investor’s craving for safety.

Investment Thesis 2016

The Six Year Bull MarketWe remain bullish on the domestic economy. We see the act of raising interest rates as a clear indication of confidence. The tightening in the labor markets will force wage increases and result in a positive growth in U.S. GDP while monetary policy will prevent the economy from overheating by keeping inflation in check. In addition, there is research that shows initial rate hikes correlate with rallies in the equity markets. The past year has seen a number of headwinds develop from Europe and Asia. The collapse in energy prices has created disruptions in a number of industries and sectors. Manufacturing was the most glaring weak spot in the economy during the last half of 2015. The broader economy continues to perform well with employment as its star.

The cost of raw materials and manufacturing continues to drop as the dollar moves upward, plaguing more than half of the groups represented in the S&P 500. Although most corporate earnings over the last few quarters have been in line with estimates, we are starting to see an erosion in both the top line (sales) and bottom line (earnings) due to the lack of investing in growth assets. Telecommunications and consumer staples sectors have not seen pricing powers deteriorate, suggesting that defensive and domestically-focused sectors and industries continue to hold the upper hand. In addition with lower trending oil prices we expect more cash to flow to consumers and we will continue to overweight investments in the consumer discretionary sector. Even though the housing sector has recently been lagging the equity markets, we are still bullish on housing. Existing home sales fell 11 percent in November to 4.76 million annualized rate from 5.32 million previously, due to buyers and the mortgage industry adapting to new regulations. The National Association of Realtors stated new regulations have disrupted home purchases and extended the closing process. Although the supply is tightening due to high prices, we think this will subside as new construction increases inventory.

Cutting Back on OilNew sectors that we are looking to increase exposure to include financials and defense. With higher interest rates, banks should post stronger earnings. Concurrent with this outlook, we are bullish on the dollar. As the difference between treasury yields and global bond yields widens, more international investors will buy treasuries and further strengthen the dollar. As global coalition efforts turn to combating ISIS and preventing further attacks, we foresee increased spending and contracts for the defense sector. We believe market volatility will most likely persist in 2016. We are managing this risk by maintaining no exposure to commodities and emerging markets until a recovery is firmly present. On the credit front, with the first rate hike in place, we are keenly focused on monitoring credit risk. It’s our duty and responsibility to be cognizant of geopolitical events—large and small, good and bad—and to consider all of the possible consequences. We are here as a steward for you and your monies. Now is the time to evaluate your investment goals and risk tolerance to ensure your portfolio is equipped to meet the challenges and opportunities of the new year. Give us a call.

Risk and Volatility

Risk is the uncertainty that an anticipated return will be achieved. Volatility measures the degree of variation in an asset’s price over time. Higher volatility means the price of the security can change dramatically over the short term in either direction. Volatility is a source of risk because one cannot be certain of the future movement of a security. Many investors view risk negatively, if managed well, it’s the key to generating gains. Investment decisions should be driven by thoughtful micro and macro analysis rather than by fear.

So what do we do to manage the risk in your portfolio? We stay with quality holdings and monitor market sector movements. We generate gains by determining sector earning trends and minimizing the cost of failed investments. We dollar cost average into an investment and manage risk while building a position in a stock or sector. We look for buy and sell signals and always monitor market psychology through technical indicators such as the put/call spread and the investor intelligence survey. We may also use cash or cash equivalents as a position in the portfolios. Cash offers flexibility for opportunistic investments. With U.S. market valuations just above the norm and non-domestic markets lagging, it’s a matter of time before there’s parity. Tuning out the noise of the media’s spin will contribute to our success and help preserve your sanity in 2016.

Changes to Social Security

There were a few big changes to Social Security in the Bipartisan Budget Act of 2015. The intent was to close some loopholes when applying for Social Security. One of the targeted strategies is File and Suspend. It allows an individual who is at full retirement age to apply for social security while simultaneously suspending benefits. 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. The new act eliminates this strategy for anyone who reaches full retirement age after April 30, 2016 and does not affect those who have already filed and suspended. In addition, there are also restrictions on claiming spousal benefits. Those who were born before December 31, 1953 may file a spousal only application when reaching full retirement age. This allows the filer to collect a benefit based on the spouse’s earnings while not affecting their own benefit. For those who are born after, the option is not available; all benefits must be claimed or none. The rules related to social security benefits are complex and there are still many other strategies available. Please contact us if you have questions regarding this topic or any other affecting your financial well-being. We’re here to help.

TOD and Real Property – Beware

Owners of real property can designate who will take ownership of the property upon the owner's death in a variety of ways. In California, an owner may do so through a will, trust, or by owning the property jointly or as community property with a right of survivorship. A revocable trust has traditionally been the favored way to accomplish the transfer of real property. California is now offering a new method (only through 1/1/2021) for conveying real property upon death: a revocable transfer-on-death (TOD) deed. A TOD deed names a beneficiary who will receive the residence as a gift upon the owner's death. The TOD deed must be signed, dated, and notarized, and subsequently recorded in the county of the subject property within 60 days of signing; no further paper shuffling is required. The transferor may revoke the TOD during their lifetime. A primary advantage of a TOD deed is that it enables an owner of real property to execute a deed naming a future beneficiary without having to go through probate. Avoiding probate should be every owner's goal for two reasons. First, the probate process freezes potential beneficiaries in legal limbo for six months to a year. Second, probate is an unnecessary waste of money, as court fees and legal fees will take a bite out of the estate. In addition, a TOD deed does not create present interest for the beneficiary. This is beneficial for gift tax purposes and it helps shield the property from the beneficiary's creditors during the life of the transferor. We encourage you to consult an estate planning attorney to see if the TOD is the right option given your wishes and family dynamics.

Revocable trusts create confidentiality, which prevents third parties from investigating the design of the trust and the grantor's wishes. Revocable trusts can also be used to create binding arrangements that control asset management in the event of incompetence. This adds a tremendous layer of security and helps ensure that your wishes and intentions will be faithfully fulfilled. Please give us a call, we can help you assemble the right team to make sure your estate plan is in order.

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All of us at Karp Capital Management thank you for your continued support over the last year. 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. We wish you happiness, good health and prosperity in the New Year!

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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