Karp Capital Management Focus

1st Quarter Report

Positioning Your Financial World in the Global Economy
April, 2016

Leaping Up and Down on Wall Street

Leap Year on Wall Street

The first quarter of 2016 was unusually volatile as the markets reacted to adjustments to the Fed’s interest rate outlook, monetary easing policies by the European Central Bank and the Bank of Japan; and, the sell-off and bounce-back in oil prices. President Obama has been on a tour of Latin America focusing on improving relations with one adversary and one old friend, Cuba and Argentina respectively. Obama’s visit to Cuba marks the first by a U.S. president in 88 years and his message on human rights was coupled with an interest in doing business with Cuba again. It will be interesting to see how the relationship evolves and how the elections could impact progress moving forward. President Obama went to Argentina to meet the new president, Mauricio Macri. President Macri has a daunting task of implementing investor friendly policies to try and save the faltering Argentinian economy. The changes in policies, both globally and at home, and the politics behind them will ensure 2016 won’t be a dull year. The stock market had one of the worst starts this year as sell-offs intensified in response to Saudi Arabia’s reluctance to cut oil production. Since then, oil prices have stabilized and consequently we have seen a steady rally bringing the index back to 2015 year end levels. The volatility in the markets, consistent with what we predicted, has caught many investors off guard and resulted in investors questioning the health of the U.S. economy. Presidential candidates are taking advantage of the uncertainty and have included policies regarding economics and business as distinguishing elements in their campaign strategies. Whether we see a change in economic policy depends, in large part, upon who is elected. In Europe, it was devastating to see another act of terror with a western target, this time in Brussels. The markets have held up in spite of these acts of terror. Heading into Q2, U.S. stocks responded to better economic data, a recovery in commodity prices, and accommodative policies from central banks in Europe and Japan, rebounding sharply from steep losses earlier in the year. Economic data have ebbed and flowed with stable new home sales offsetting disappointing existing home sales while durable goods orders remain weak but stable. The U.S. economy remains solid; modest wage gains and low unemployment point to ongoing health in consumer spending. In this issue of Karp Capital Focus we will outline changes in asset allocation and investment focus as markets around the world grapple with waning growth, diminishing sales trends and ongoing volatility.

In This Issue:

Leaping Up and Down on Wall Street

Market Performance

The Fed Rides Again

The Domestic Economy

The Global Economy – Honey It's Cold Outside

Global Politics Brexit (Britain’s Exit)

Personal Finance and a State of Mind

Reading the Tea Leaves and the T-Notes

Investment Strategies at Karp Capital

Finding Value in a Reverse Mortgage

Life, Money, Legacy and What Matters

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Market Performance

Here are the performance numbers for the major indices as of 3/31/2016

March
2016

Latest
3 Months
Latest
6 Months
2015
% Change
Dow Jones Industrials
7.08%
1.49%
8.60%
-2.23%
Standard & Poor’s 500
6.60%
0.77%
7.28%
-0.73%
NASDAQ Composite
6.84%
-2.75%
5.40%
5.73%
Russell 2000
7.98%
-1.92%
1.21%
-4.41%
MSCI EAFE
6.02%
-3.74%
0.46%
-0.39%
Long Term Treasury Bonds
-0.11%
8.22%
6.88%
-1.29%
Gold
0.17%
16.70%
11.04%
-11.61%

The S&P 500 gained 6.6% in March. The rally in the index was led by the smallest, least expensive and lowest quality stocks, although high quality stocks still lead for the year. Energy stocks returned +9.18% in March, while Utilities (+7.69%) and Telecom (+6.26%) continued to benefit from low interest rates. Health Care was the worst-performing sector for the month (+2.59%) and for the year (-5.93%). The S&P 500 posted its best March returns since 2009, when the stock market last bottomed.
Sources: Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML




The Fed Rides Again

The Fed Rides AgainAt the time of the December 2015 Fed rate hike, many investors and economists thought the Fed was signalling four rate hikes in 2016. The Fed has changed its tune acknowledging that the volatility in the markets and the concerns expressed by investors is something not to be ignored. On March 16th, Janet Yellen announced that the Fed decided against raising rates. The Fed is now expected to make only two interest rate hikes for the rest of the year instead of four. After all, Yellen and her cohorts do not want to go down in history as having raised rates into a possible recession. Some see the Fed’s action as a sign of caution rather than a reason to worry. We think the Fed Governors missed the opportunity to raise rates the middle of last year and any rate hikes in 2016 would be a mistake. To focus on the Federal Reserve at this point for economic guidance is a moot point. Any interest rate increases are still data dependent, meaning that the next interest rate increase (if any) would depend on realized and expected economic conditions. The doves on the Fed do not want to raise rates, but will do so only if inflation and market rates force their hand. The FOMC (Federal Open Market Committee) statement also said that recent market developments and the global outlook "continue to pose risks”. This is essentially an admission that the Fed is watching global events, such as the European Central Bank's aggressive quantitative easing and negative interest rate policy. The treasury markets and not the Fed should be watched closely. U.S. Treasury yields have been trending lower in the wake of the Fed's latest guidance. We think the Fed is usually overly optimistic with both its inflation and economic growth forecasts. The Fed has lowered its own 2016 GDP and inflation forecast from December. The Fed should re-examine its inflation forecasts, since deflation is now the dominant trend - not inflation. The Labor Department reported that the Producer Price Index (PPI) declined 0.2% in February, the fifth monthly decline in the past seven months. Wholesale energy prices declined by 3.4% (gasoline prices declined 15.1%) and wholesale food costs declined 0.3%. In addition, the Consumer Price Index (CPI) declined 0.2% in February, due largely to a 6% decline in energy prices. In the past 12 months, the CPI has risen just 1%, well below the Fed's 2% target, so the Fed is under no pressure to raise interest rates.

The Domestic Economy

News headlines, often touting light humor of political missteps and celebrity gossip, have recently been rife with the fear of a looming recession. Adding to the panic, large banks like JP Morgan and Morgan Stanley have independently issued statements concerning the risk of a recession. Are we headed towards a recession? Before we dive into our outlook, it is important to note that statements issued are representative of different departments and there is a dichotomy of opinions held within the banks. For example, Morgan Stanley representatives issued a statement warning of a recession in one news outlet while also issuing a contradictory statement in a separate news outlet stating they can see U.S. growth continuing until at least 2020. Firstly, a recession is defined as a negative Gross Domestic Product (GDP) growth of two successive quarters. According to the definition, if we look at the change in the GDP growth rate over the latest six months, we don’t see a two-quarter contraction and are not in or near a recession. Specifically, real GDP in the 4th quarter of last year grew at a positive rate of 1% and 2015 as a whole showed real GDP growth of 2.4%. Secondly, we are also in the middle of a strengthening labor market. 242,000 jobs were added in February to keep the unemployment rate at 4.9%, a level considered to be approaching full employment. While lagging the labor markets, wages are starting to pick up. The economic cost index, which takes into account benefits as well as earnings, gained 2.1% in the last three months in 2015. Additionally, in February the Purchasing Manager’s Index conducted by the Institute for Supply Management grew 1.3% compared to January, signaling a pickup in manufacturing. Manufacturing has been a concern for some time now due to the buildup of inventory and the slowdown in manufacturing seen in the last few quarters. With recent positive growth, however, a recession would only occur if there were a complete reversal for the next two consecutive quarters. We think the likelihood of an imminent recession is minimal. This does not mean we will not see an economic slowdown this year. The speculation in private companies, high tech in particular, is coming to a cyclical end. The weak global IPO issuance across the world fell nearly 40% to just over $12 billion in the first three months of 2016, marking the weakest showing since the financial crisis. Some of the biggest banks and issuers cite falling oil prices, a strengthening dollar, and weaker economic conditions globally and market volatility as reasons to hold back new IPOs. The trickle of IPOs can be seen as a positive in some sense. A flood of IPOs can indicate a frothy market and the number of issuances are used as a contrarian indicator to the health of the equity markets. A lot of these companies are having trouble funding their losses internally and are having trouble accessing external funding. Layoffs have begun in many of these companies. When money is being raised it is at lower valuations than the previous round of financing and the cycle is now in reverse. Also, the latest Existing Home Sale numbers for closed transaction volume made a new 13-month low. Looking forward, we’re focusing on the Pending Homes Sales (PHS) data for February as it will give us a read on March Existing Home Sales. As it stands, PHS have decelerated for 9-months off the April 2015 rate-of-change peak and we continue to expect sales in the existing market to decelerate through the first half of 2016. The housing industry is a larger job creator and with a strong possibility for flat to negative mid-single digit volume, growth could represent an additional headwind for housing related equities and the economy.

The Global Economy – Honey It's Cold Outside

Riding the Crude BarrelA European recovery has been hinted at and hoped for recently. Meanwhile investors are sitting on the sidelines waiting for signs that Europe is ripe for growth again. A year ago, in an attempt to stimulate growth and raise inflation to target levels, the European Central Bank (ECB) initiated a 1.1 trillion Euro asset-purchasing program. This strategy, known as Quantitative Easing (QE), is sometimes an effective economic stimulus when standard monetary policy isn’t working. Unfortunately, the geopolitical turmoil, including vast numbers of migrants pouring into Europe, have not accelerated growth to anticipated target levels. In December, the ECB decided to extend the length of the QE program to provide additional stimulus and on March 10th of this year, the ECB increased its bond buying by a third. This caused the interest rates on sovereign bonds of many European nations to fall below zero. In general, Europe is handicapped by the limited size of its financial markets. Because European companies are more inclined to borrow from banks than to issue bonds, they limit their own access to capital which, in turn, creates a reduction in liquidity. All of these factors have impacted the effectiveness of the ECB’s QE strategy. The Bank of Japan surprised global markets in January by adopting this negative interest rate policy. Prime Minister Abe and the Bank of Japan’s Governor have tried to create inflation in Japan by weakening the currency but have failed to do so. Japan has been struggling to grow for some time and policy makers are running out of stimulus options. In a negative interest rate environment, the central bank charges for deposits at commercial and local banks that exceed the required minimums. Although this deposit penalty is a strong spending motivator, it is still unknown how quickly the benefits of negative rates will help Japan, which has been in a low rate environment for some time now. The Japanese economy is shrinking and deflation is a reality. Across the Sea of Japan, China has been steadily cutting interest rates for some time now to stabilize the large volatility in the Chinese stock markets. The strategy seems to be reducing the flow of money out of China. If it will be enough in the long term is yet to be determined. These policies abroad further support our view that the U.S. economy is now standing on far firmer ground than what you will find in most of Europe and many other parts of the world right now. Given how many financial headwinds have developed outside of America’s borders in recent years, the U.S. economy is currently the best place for investors.

Global Politics Brexit (Britain’s Exit)

Europe and RefugeesRecent discussions regarding Britain’s contemplated exit from the European Union have investors worried and wondering about the repercussions. David Cameron, Britain’s Prime Minister, announced that Britain will hold a referendum on June 23rd to determine whether it will remain in the European Union. Why is Britain considering leaving and why now? Britain has always been reluctant to be lumped in with the rest of its neighbors. After WWII, labor governments in Britain turned down the opportunity to be part of the negotiations that created the forerunner of the EU. In 1973, the Tory government of Britain joined the European Communities due to the prosperity of Europe as a whole. In the 1990s, a number of European countries agreed that closer monetary integration through a single currency, the Euro, would be beneficial and took steps to realize the creation of the Eurozone. Britain declined to join the single currency and has chosen not to be a member of the Schengen passport-free travel zone. There is already ample frustration about the legal migrations of East Europeans looking for work under the current EU rules. Britons see passport-free borders as a threat to jobs, housing, schools and health services. If a Brexit does happen in June, the consequences are unclear. The immediate changes would be a restructuring of benefits and welfare payments to migrants. Policies would be enacted to protect Britain’s trade balance, possibly by the use of tariffs. British banks might be subject to new Eurozone regulations that would limit the flow of money and Britain, as a whole, could look less attractive as a destination for foreign investment. It would remove itself from the ability to set policy (they’d be a spectator) that would affect the market. While the world waits, the uncertainty will make itself known in the markets across the pond.

Personal Finance and a State of Mind

Our discussions with clients and other investors during Q1 2016 were very different than in times past. The bi-polar nature of investors, super-cautious when stocks are low and complacent near market peaks is of great concern. The willingness of so many people to believe that some kind of new crisis (whether recession or hyperinflation) is just around the corner is a testament to just how much damage took place during the financial crisis and its aftermath. When people withdraw money from equity funds, stocks tend to rise. According to data (going back to 1984) compiled by Bloomberg and the Investment Company Institute, "in the 12 instances when funds experienced monthly outflows that were at least two standard deviations from the historic mean, the S&P 500 rose an average 7.1% six months later, compared with a normal return of 3.9%”. Fear is not based on analysis and robs investors of market gains.

Reading the Tea Leaves and the T-Notes

The Six Year Bull MarketAs we’ve stated in past newsletters the bond market rules the world and eventually prevails as to the true health of the economy and inflation trends. Bond buyers are not selling even though there are talks of the Federal Reserve raising rates. The 30-year T-Note is currently paying in the range of 2.60%. The rally in stocks has been dominated by the deep cyclical sectors, which tend to rally as the economy starts to grow. This makes the resilience in the bond market that much more impressive, as yields typically rise sharply when money is flowing into economically sensitive stocks. The 30-year yield is still at its long-term (down-sloping) trend line that has defined the broad macro deflationary landscape. The prevailing fear given the dramatic sell off in the stock market in the first quarter was that the U.S. economy might slip into a recession and that falling oil and commodity prices might lead to a period of deflation. In addition the rate of change in the economic data is supporting the movements in the bond market. Does the current sell off in the dollar, the recent rally in oil prices and the rebound in high yield bond prices signal a turn in the market? The question is do you believe the massive Quantitative Easing measures announced by the European Central Bank, Bank of Japan, and People’s Bank of China will stimulate those economies which in turn will boost U.S. export trade? We would be more optimistic if the current market rally would stem from growing corporate revenues and solid balance sheets. If you look at the top performing sectors and stocks in March, the S&P 500 Energy, Materials, and Industrials Indexes are rallying in tandem. The question is why? Perhaps the selling pressure became so exhausted that many were just waiting for the inevitable snapback. When investors started asking, how low can it really go, the bargain hunters begin stepping in. Dividend yields became so attractive that short-covering rallies are ignited by investors looking for yield. The reality is we wouldn't see major central banks offering negative interest rates and the Fed continually pushing out normalizing interest rates here in the U.S. if the global economy was improving. We believe the treasury market has it right- slow economic growth, wide market swings and increasing volatility is the call for the next couple of quarters.

Investment Strategies at Karp Capital

Our views on the current market environment, unchanged for the past two quarters, have been supported by recent developments. In previous newsletters, we mentioned that the volatility seen for most of last year will be here to stay for a while and that appropriate risk management is essential. We maintain our stance that global markets are still fraught with volatility and large downside risks. We continue to believe that international exposure will not provide a favorable risk to reward trade-off until major concerns over growth are addressed and leveraged bets on unrealistic forecasts are settled. Accordingly, we will focus our efforts in the markets at home. Within the domestic markets, we have identified opportunities in the recent sell-off. Investor mogul Warren Buffet is famous for the statement, “Be fearful when others are greedy and greedy when others are fearful”. We viewed the panicked selling after oil hit $26 a barrel as a disconnect from fundamentals and an opportunity. We decided to dollar cost average into the energy sector, which had taken the brunt of the selling. Since then, oil has started to recover (oil is currently trading around $37 a barrel) and the large surpluses have been reduced. We are also looking into the commodities market as a place to hedge risk. Commodities have been sold off in recent months because of China’s slowing economy and the reduced demand for raw materials. Despite China’s slowing, the world continues to revolve and new appliances and materials have to be created to replace old and broken ones. We are looking for the right opportunity to take our position. Lastly, with consumer confidence at highs, we have maintained key positions in sectors that will benefit. These include consumer discretionary, consumer staples, automobile companies and payment processing companies. We believe that the strength of the U.S. consumer will lead to more profitable months and quarters ahead for these companies. As they report an increase of revenue, their stock prices should appreciate as well.

Finding Value in a Reverse Mortgage

There is potentially great value in beginning a reverse mortgage as soon as eligible (age 62) for those with a reasonable expectation to remain in their home. The idea is to begin the reverse mortgage early, even if proceeds from it may not be taken out for many years. There are no loan repayments while you live in the house. Repayment is generally only due when you move, sell the home or die. The importance of effective distribution strategies is rapidly increasing as millions of baby boomers approach retirement over the next decade. One of the top concerns of pre-retirees is “How am I going to generate consistent income in retirement given my current lifestyle”? The diminished role of defined benefit plans, longer life expectancy, escalating health care costs, and volatile stock market returns are just a few of the issues confronting people thinking about retiring or newly retired. It is prudent to establish a line of credit through the HECM program (Home Equity Conversion Mortgage) whether you need the money immediately or not.

Reverse mortgages give homeowners an advance on their home equity and allow them to delay repayment until the home is sold. In the past, these types of programs were used for those who didn’t prepare financially for retirement. But an overlooked advantage is that the lines can be used to smooth out your income stream in the case of unexpected expenses. Now, with homeowners’ worries about declining home values and negative equity, one of the advantages of the federally insured reverse mortgage is that the government assumes some of the risk for the borrower. HECM borrowers cannot end up on the hook for negative equity.

Another benefit of the program is the loan balance on a reverse mortgage grows over time. In some situations a line of credit makes more sense than borrowing a lump sum and keeping it in reserve because the unused portion of a line of credit grows over the years, giving the homeowner access to more cash. Reviewing your income plan during prolonged bear markets or severe market drops, along with this strategy, has the possibility of further increasing the chance of success in retirement. Reverse mortgages can be a valuable way to supplement a retirement income plan, fund unexpected expenses or take advantage of other investment opportunities. Call us to see if a reverse mortgage is right for your retirement income strategy.

Life, Money, Legacy and What Matters

The Six Year Bull MarketWe may not know how our decisions influence others after we’re gone, but it matters just the same. History is full of people whose influence was most powerful after they were gone. It does, however, bring the question of financial planning to mind. Specifically, ensuring your spouse, family and friends are taken care of. Not just in terms of financial resources, but also in their ability to assume management of finances and general activities. To put things bluntly, would your spouse, significant other or child know how to access your financial accounts, life insurance and other information that affects others if something suddenly happened to you? Would they even know what financial firms to contact? It is important to have these conversations with the people you care about and that care for you. Knowing their wishes and sharing moments of truth are crucial. If we ask how we want to live; what we seek from life, and what makes life meaningful for us then we need to ask questions. Most people would probably agree in the end what they want is happiness. We have a tool at Karp Capital called the share your life cards. Please give us a call for a tutorial on how to leave a legacy for the next generation.

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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 preceding analysis, or would like to review your portfolio’s performance, please call us at 877-900-KARP. At Karp Capital, we care about your financial world and how it is positioned 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 Financial 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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