Karp Capital Management Focus

3rd Quarter Report

Positioning Your Financial World in the Global Economy
October, 2016

Where are the Election Year Jitters?

Election Jitters

To paraphrase Charles Dickens, Q3 was the best of times and it was the worst of times. We saw all-time stock market highs, and stabilizing oil prices. At the other end we experienced higher market volatility and more global immigration issues. It was the age of wisdom (continuing technology breakthroughs) and also the age of foolishness (the election). It was the spring of hope (low interest rates) and it was the winter of despair (uncertainty about Q4). Since the eerie period of calm this past summer, volatility crept into the financial markets at the end of Q3. Stocks and bonds moved as a pair in September, and the correlation between them hit a 17 month high. Following a modest pullback at the start of September, stocks had been treading water as investors waited for the sage words of Fed Chair Janet Yellen on monetary policy. Most pundits expected the Fed to hold off on an interest rate hike until at least December and that’s exactly what happened with rising yields on the 10 year U.S. Treasury Note signaling future rate increases. On Capitol Hill it was embarrassing for Wells Fargo’s CEO, John Stumpf. He told a version of the truth about defrauding bank customers. By contrast, Europe’s bankers haven’t yet been forced into ‘under-oath non-fiction’. The U.S. economic data is still mixed. The jobs report in August showed some disappointing results, 151,000 jobs were added to the domestic economy vs. a forecast of 180,000. However, for the third straight month, the unemployment rate held steady at 4.9% and wages continued to edge higher each month this year. Congress showed that, once in a while, it can actually put partisan politics aside: a stopgap spending bill was passed and then, at long last, funding for Zika virus research. U.S. home sales are up 20.6% year-over-year and the 12 month sales average was the highest since September 2008. The coming winter months may see a volatile housing market but we believe the tide has truly changed with an improving economy and wage growth.

Economic numbers are starting to stabilize around the world. Officials in the U.K. believe a recession will be avoided, something many feared following the Brexit vote. There are signs of improvement in the global economy that should encourage businesses to take on more investments and investors to take a cue from central banks that inflation is tame with supportive monetary policy reigning supreme. The markets are discounting what will happen after the November election; most indices are at or near record highs. This could affect portfolio performance over the next few quarters as the market finds its footing. With all this, where will the markets be at the end of 2016? Will the presidential election trigger a relief rally or a drop in equities? Will there be a November Surprise? How stable will foreign markets be in Q4 given a possible Brexit fallout and upcoming Italian elections? In this installment of Karp Capital Focus, we will address these questions and what will likely drive the economy to determine your portfolio allocation and performance.

In This Issue:

Where are the Election Year Jitters?

Market Performance

Rate and Switch

London Calling: LIBOR

A Real Risk

When Greater Profit is Our Loss

State of the Markets

Investment Themes

Secondary Markets – Sneakers to Beanie Babies

The Election

Estate Planning: Don’t Be Dead Wrong

Top Retirement FAQs

IPOs & Industry Transformations

 

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Market Performance

Here are the performance numbers for the major indices as of 9/30/2016:

Latest
1 Month

Latest
3 Months

YTD
The
Close

Dow Jones Industrials
-0.50%
2.11%
5.07%
18,308.15
Standard & Poor’s 500
-0.12%
3.31%
6.08%
2,168.27
NASDAQ Composite
1.89%
9.69%
6.08%
5,312.00
Russell 2000
1.11%
9.05%
11.46%
1,251.65
MSCI EAFE
0.96%
5.80%
-0.85%
1,701.69
Long Term Treasury Bonds
-1.70%
-0.63%
14.76%
Gold
1.01%
0.13%
24.76%
VIX (Volatility Index)
-0.97%
-14.97%
-27.02%

After hitting new highs, the S&P 500 ended Q3 with returns of +3.9%, outperforming investment grade bonds (+1.4%), gold (+0.1%), cash (+0.1%), and long-term treasuries (-0.6%). Q3 was ‘risk-on’ as large cap U.S. stocks lagged small caps (Russell 2000 +9.0%) and non-U.S. equities (MSCI World ex-US +7.0% in USD). Tech (+12.4%) and Financials (+4.0%) were Q3’s best-performing sectors while defensive sectors were in the red with the exception of Health Care (+0.5%). Bond-proxies were the worst performers (Utilities -6.7% and Telecom -6.6%). In terms of other styles, the widest spreads in Q3 were in high beta stocks (+11%) relative to low beta stocks (-3%) and low quality (C&D ranked) stocks (+12.9%) vs. high quality (A+ ranked) stocks (+0.2%). It was a wild quarter.
Sources: Thomson Reuters, WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML, Ned Davis Research. Stock market indices do not include reinvested dividends.




Rate and Switch

We know that this is a very calculated Federal Reserve that has threatened to raise rates numerous times over the last year. We also know the Fed wants to raise rates to give itself maneuvering room in case the economy weakens or goes sideways. As recent history has shown, we know the Fed doesn’t wear blinders and understands market reactions to its policy moves. In fact, Chairwoman Yellen declared that Fed purchases of stocks/bonds could help in a downturn. This is a bold idea given she has stated that the economy is prepared for an interest rate increase. According to Janet Yellen's Q&A session at the end of September, the U.S. economy and labor markets are doing well. Before implementation, the legislative branch would first need to approve such an unconventional move. The rhetoric just doesn't add up. If the U.S. economy is doing so well and financial assets are not overvalued, why would there be talk about intervening directly in the markets? This is what is happening in Japan with negative effects-financial assets inflating and no economic growth, a rising yen and deflation. The answer is rather simple. The Federal Reserve is nervous about raising interest rates in this economic and political climate. Outside the U.S., interest rates across the globe are exceptionally low with the German, Japanese, and Swiss 10 year bond yields all remaining negative. Yields throughout much of the rest of the developed world are hovering at 1% or below. If U.S. rates were to rise too quickly, it seems likely that buyers from around the world would step in, constraining the upward move in treasury yields. Also, if economic data does not improve and the Fed sees fit to raise rates more than once, the increases will be ahead of where the economy is. An improving economy could provide an offset to higher rates, putting pressure on bonds, and fostering a stronger dollar. Given how measured today’s Fed is (it has been nearly 10 months since the last hike) we know it has become less central as a barometer for investors given the muddled message on the economy and monetary policy. We don’t think that the data will support sustained rate increases in the foreseeable future. Because of this continuing rate and switch with the Fed, we are focused on positioning portfolios for the long-term with a diversified allocation focusing on principal protection. One thing is certain, interesting times are ahead.

London Calling: LIBOR

Over the last couple of years, rumblings of money market reform have occasionally popped into financial news headlines. Most stories are laden with industry jargon and only seemed to matter if you were managing a money market fund or in charge of ensuring the solvency of a major financial institution. However, effective October 14, 2016, prime institutional money market funds will be required to float their net asset values, rather than fixing them at $1.00 per share. Why should we care? What does that mean for the long-term? The potential deviation from $1.00 means that fund managers have a responsibility to manage the liquidity of the investment. If you’re invested in a non-government money market fund and there’s a financial crisis similar to 2008 and the fund’s liquidity falls below defined limits, it can impose redemption fees or reduce quick access to your money. This helps prevent, or at least mitigate, potential runs on the banks. But the restrictions aren’t applicable to money market funds backed by government debt. This has had some unintended consequences to London Interbank Offered Rates (LIBOR). In fact, in the last three months, the LIBOR rate has spiked in response to a major reduction in money market demand for short-term international bank financing. With LIBOR set to bank rates and not government rates, it’s possible that LIBOR could find new equilibrium at a higher interest rate and a higher spread relative to U.S. Treasuries. Because the investment world has been focused on the Fed’s decision, the LIBOR spike has come out of left field. This may spell the beginning of longer-term tightening effects similar to the Fed’s impact when it tightens policy. You see, different kinds of loans are generally set to different rates. For example, many home loans are tied to treasury rates while most commercial loans are tied to LIBOR. This means that the recent higher shift in LIBOR will affect businesses more immediately than consumers. The result could be that the Fed may be able to postpone rate hikes even further. At Karp Capital, we monitor interest rates and the spreads between different fixed income securities to see how the markets might force Janet Yellen’s hand prior to the next possible rate hike in December.

A Real Risk

Bank Rip OffIn the near term there will be more pressure on U.S. and Europeans banks. Wells Fargo CEO John Stumpf was grilled by members of the House Financial Services Committee over the bank's unauthorized accounts scandal. Stumpf has agreed to forfeit $41 million in stock options. House members are calling for a criminal investigation, looking for an opportunity to break up the bank and political grandstanding. This gives politicians in Washington something to investigate and other major money center banks are going to come under greater scrutiny. Keep in mind, during the financial crisis no major banking executive lost their job or was fined. This is an attempt for politicians to redeem themselves in the eyes of their constituents. It will be difficult to grow the economy if banks are afraid to take on risk and lend money to businesses and individuals. In our clients’ portfolios we have very limited exposure to the big money center banks. On the other side of the pond, one of the largest banks, Deutsche Bank is down over 49% for the year and may need to raise capital. Conflicting reports exist on the bank, as Germany's Chancellor Angela Merkel ruled out any state assistance for the lender, but the CEO John Cryan denies ever having asked for help. Front and center is Deutsche Bank’s legal issues with the U.S. Justice Department. The Justice Department could seek up to $14 billion in penalties, which would severely bruise the bank, but in reality the settlement amount will likely be lower. Markets are trying to price-in the worst case scenario but no one knows the unintended consequences. In addition the selling pressure has mounted in light of negative interest rate policy (NIRP) that is hurting net interest margin and profits not only for Deutsche Bank but all banks throughout Europe. Though there seems to be no liquidity risk there are capital concerns. This is a very different situation than the liquidity risk we saw during the financial crisis. Capital erosion destroys a bank over time; lack of liquidity shuts down the system overnight. These are the situations that we monitor regularly and may impact our asset allocation decisions in clients’ portfolios. Please keep in mind this is not new news. Our focus is always working to identify situations and take action before such issues morph into a problem for the portfolios.

When Greater Profit Is Our Loss

Media Corp Control“Just because your voice reaches halfway around the world doesn't mean you are wiser than when it reached only to the end of the bar.”
– Edward R. Murrow.

It is no surprise that global 24 hour news is a profit-driven entity. When Murrow suggested that reach did not equate to content, he may have foreseen how the news has changed since his time. When the networks were new it was all about the responsibility to inform the public, exempt from profit and driven by a sense of moral obligation. Enter the 24 hour news cycle where ratings matter and sensationalism proves itself valuable to entice viewers. The drama of presidential politics bears this out. Do we really understand where the nominees stand on the issues that affect us each day? The uncertainty plaguing the market this year tells us… no. Stories about celebrity scandals are broadcast nonstop while important national and international news is ignored. As profits rise at news media outlets, the quality of the information diminishes. Edward R. Murrow and his colleagues would not agree that news becoming business is an improvement. The spectacle created to attract viewers has left the public less informed. Despite the plethora of information afforded by the internet, we run the risk of navigating only to articles that fit our profile. Viewing customization, backed by complex algorithms minimizes our choices of how we view the world.

State of the Markets

Economic Growth Sort OfInvestors are dealing with an increasingly frustrating market. Despite all of the bullish and bearish talk, the overall market hasn't gone anywhere for quite some time. At the start of Q4, the Dow is trading where it was 1 ½ years ago, while the NYSE (largest index by capitalization) is trading at levels first seen 2 ½ years ago, all while earnings have been declining. The market has been locked in a tight trading range, while breaking into new high territory in July. It may take some proof that the earnings recession is behind us before the market moves higher. The yield on the 10 year Treasury Note, which had fallen to a record low 1.37% immediately following the Brexit vote, rose to 1.73% in early September. Financials came under pressure due to concerns about Deutsche Bank’s financial stability. Investors, fearing another Lehman-like event drove shares to multi-year lows. We expect the slow-and-steady global economic expansion to grind on and market volatility to continue. Investors will focus on Q3 earnings and corporate outlooks for 2017. While there are some weak spots within the economy (especially manufacturing), the broad economy continues to claw its way higher. Gross Domestic Product numbers for the 2nd quarter of 2016 has been revised three times and stand at 1.4% vs the first quarter, and real GDP increased 0.8 percent. The numbers are better but stale data makes it difficult to make forward investment allocations. Personal consumption figures remained firm on lower gas prices and a slight uptick in wages. Economic data in the U.S. is much better compared to what is happening in much of Europe and Asia. We continue to look for value in a market that is rewarding companies and sectors with bubble range earnings as the Federal Reserve contemplates how to raise interest rates. We have been mitigating this environment by forming barbell portfolios, whereby we mix low volatility sectors and investments with high growth holdings. Please call us if you have any questions on the sector focus and how your portfolio is allocated. Since the economic expansion has become extended fewer and fewer stocks and sectors will lead the market higher. There is more to balancing a portfolio between stocks-bonds and cash than meets the eye.

Investment Themes

Correction CoasterThe 3rd quarter’s theme of growth over value will be central as we head into year end. We should continue to see domestic assets outperform foreign assets and also start to see some bumps in small cap performance due to extended valuations, falling growth estimates, and rising volatility. The following questions will continue to weigh on the markets… Will the Fed raise interest rates in December? Do equity valuations and public debt present investment opportunities? Is the health of the economy supportive of better corporate earnings, controlled inflation and a stronger GDP?

Managing Risk
As always, the performance of the major indices should not be the focus at the end of an economic cycle, it should be the risk you are taking on. This is an issue for investors who cannot take a step back and make their nest egg again, especially if you’re in your 50s and 60s.

Size and Quality Matters
With volatility set to rise and performance waning, large-cap companies tend to hold up better than small cap companies. Investors gravitate to higher quality holdings because of the rise in volatility. We think profit taking in small cap companies will continue and this puts pressure on small cap indexes.

Mergers and Acquisitions Sets Record
Larger companies are flush with cash and need to grow and so they will buy mid-size companies. When Mergers & Acquisitions pick up, small companies tend to lag large companies by a wider margin.

The last 20 months have featured an endless loop of the same questions about rising interest rates, valuations presenting opportunities, the economy’s health and the election. Except for the election, the other questions remain pieces of a puzzle that can be categorized by one word: markets. Despite the economic and political backdrop, the markets have reached new highs over the last quarter, while the S&P 500 is exactly where it was in May 2015. This leads investors to ask why their portfolio isn’t making money. The answer is that valuations are stretched and most equities look fairly valued or slightly overvalued, while bonds appear to be a riskier-than-usual alternative. We believe that maintaining a portfolio that is diversified is crucial, and reducing the risk of principal erosion on the fixed income side is equally important in case we have a market downdraft. Looking forward, we believe earnings will be better than analysts expect, but the bar is higher than the past four quarters. Entering year end, higher risk assets should perform the best. Large cap technology and biotech remain a top sector focus but they do add more risk to the portfolio. The consumer is healthy but spending trends are more on experiences than on accumulation of material items. For income, our focus is on Municipal and U.S. bonds as foreign buyers are going to drive yields lower and push bond prices higher. Keep in mind we were at a 2.3% yield on 10 year Treasuries after one hike in December 2015 and 3% in December of 2013, two years before any Fed action. Having cash ready to deploy is an asset class that will serve us well given the market environment.

Secondary Markets – Sneakers to Beanie Babies

Remember when Air Jordans were the hottest sneakers on the planet and people waited in line all night to purchase them? What sold at retail for $200 at the Nike store is now worth over $4,500 on StockX.com, a web-based secondary market for high-end shoes in original boxes and unused. StockX launched in February with thousands of pairs of sneakers available for a 10% commission. It’s worth noting that the shoes are deadstock, or no longer available on the manufacturer’s eCommerce sites. Like the stock market with ebbs and flows and real-time pricing, there’s an index for each major brand. As of 9/28/16, StockX included the Jordan, Nike and Adidas indices. The website maintains each trader’s anonymity, validates each order for authenticity, condition of the sneakers, and emphasizes price transparency. You might still find some Air Jordans or LeBron James vintage sneakers on eBay, but StockX is the place to go now.

StockX has emerged as a trailblazing eCommerce company for the sneakers you can buy for investment purposes—as well as other types of collectibles like watches, handbags and toys. Sounds a lot like eBay all over again. What this means for our clients… at Karp Capital we are constantly looking for interesting investable financial stories. After all, something as unassuming as a pair of vintage sneakers launched this growing eCommerce phenomenon. Who knows what will be the next new thing to catch the eye of investors?

The Election

Chris Matthews

Chris Matthews, host of MSNBC’s Hardball always asks his guests, “Tell me something I don’t know.” Here is Karp Capital’s take on what we do know about the November 8th presidential election:

  • We do know that this election is currently a toss-up
  • We do know that it will affect the stock markets
  • We do know that it will affect the global economy
  • We do know there’s a high level of angst that could be a catalyst for a sell-off and heightened volatility or a new bull market

How do presidential elections normally affect the markets? Since World War II, stocks have gained ground under each U.S. presidential election cycle except Richard Nixon and George W. Bush. Some call this a Relief Rally because investors are thrilled that a new president is taking office, as well as because all the political ads, debates and media coverage are mercifully over. Others may be scared of what the future with a new Commander-in-Chief will bring. But most investors will probably look at their portfolios with fresh eyes. Furthermore, a Relief Rally can take place across a myriad of markets, including stocks and bonds, oil and other commodities, or it can be the result of elections, unimpressive corporate earnings, or overseas events such as Brexit. 

Over the past 70 years, the Federal Reserve has tightened monetary policy as a tool to slow inflation which has triggered most recessions. The 2016 presidential nominees are now drawing lines in the sand with their fiscal stimulus positions on corporate tax cuts, immigration laws, security, healthcare, foreign policy, and jobs creation—which will create a wealth effect. As we’ve said, we know that Trump or Clinton will win and that may affect the markets, that’s why Karp Capital is looking at the big picture for balancing your portfolio with a long-term position towards your retirement while focusing on principal protection, Relief Rally or not.

Estate Planning: Don’t Be Dead Wrong

Inheritance TaxIn our last newsletter, we wrote a story about Prince. This issue, we’re expanding our advice about estate planning for your family’s future. Sting is a musical icon who is not concerned about the potential inheritance of his fortune of $300 million. He has said, “I certainly don’t want to leave them (his children) trust funds that are albatrosses round their necks”. Prince left an estate estimated at $250 million to the courts with no spouse or children and both parents deceased. Similarly, actor Phillip Seymour Hoffman’s fortune was worth approximately $35 million. Like Sting, he told his accountant that he did not want his children to be considered trust fund kids. Two of these celebrities were dead wrong—and the third is making a costly mistake. Financial planning and estate planning are essential when you have a family. A living trust is a road map on how to handle your affairs when you can’t. It is a legal document through which your assets are placed into a trust for your benefit during your lifetime and then transferred to designated beneficiaries at your death. Why is a living trust so important? For starters, 70% of wealthy families lose their wealth by the second generation. Even worse, 90% lose it by the third generation. There is a difference in trying to control your fortune and the people you leave behind and a sensible estate plan to minimize taxes and maximize liquidity for your loved ones. You should offer your family a financial roadmap to create a sense of financial responsibility. In the case of vast wealth, a charitable family trust is designed to save on income taxes through an upfront tax deduction, while heirs receive an income stream over their lifetime. There are other strategies that are here today, but will be gone tomorrow. New regulations are coming that will make it difficult for families to engage in valuation discount planning. Right now might be the last opportunity to benefit from longstanding exemptions that can save you significant dollars. Valuation discount planning applies to estates worth more than $5.45 million (or double that for married couples), which accounts for about 0.2% of those who die each year. Talk to us at Karp Capital about getting your affairs in order. Now is the time to review or start your financial and estate plan. This is a very important part of how we help families reach their long-term financial goals.

Top Retirement FAQs (frequently asked questions)

Are you planning for your retirement but getting cold feet? Do you worry about not having enough money to carry you through the next 20 or 30 years? Don’t worry and start planning. Here are the most common questions asked about retirement. Karp Capital is here to keep your planning on track and answer your questions:

  1. Am I saving enough for retirement?
  2. Am I under-estimating my retirement expenses? 
  3. How high will my housing and healthcare costs rise?
  4. How diversified should my portfolio be?
  5. How much will lower projected returns affect my income?
  6. When should I start receiving Social Security?
  7. When should I sell my home and downsize?
  8. When and how should I reduce my spending?
  9. How much should I bequeath to my children and grandchildren? 

We provide realistic scenarios and projections. If you’ve saved for retirement for 20 to 30 years or if you invested in a home decades ago, you have the foundation to enjoy your retirement years without angst. We focus on building your portfolio for the long-term, design income strategies and provide guidance when you need it.

IPOs & Industry Transformations

So far, 2016 has been the worst year on record for IPOs, with only 63 new companies listing on stock exchanges, raising a paltry $13 billion and banks taking in just $3.7 billion in fees. It looks like the IPO market is due to gain some steam in Q4 and 2017. A few potential IPOs have actually transformed several industries, which will have a tremendous impact on investments in the hospitality and transportation sectors. One example is Airbnb, which is revolutionizing the hospitality industry with over 30 million guests since it was founded in 2008. Meanwhile, Lyft and Uber have forever altered how people get from Point A to Point B in major cities around the world. Airbnb has raised $850 million at a $30 billion valuation in a funding round that was led by Google Capital. These funds will help Airbnb go public and help the company with its international expansion. Uber has realized explosive growth and could be one of the largest tech IPOs ever with a valuation in the neighborhood of $65 billion after raising $15 billion to date. Uber is aggressively forming partnerships in large U.S. cities. Lyft has a valuation around $5.5 billion and has raised $1.5 billion to date. Because more than 25% of Americans 65 years or older do not own smartphones, Lyft is smartly partnering with AARP to provide rides for seniors. So what do these emerging technologies mean to your portfolio? Technology is continuing to transform our lives. Two major sectors are now experiencing rapid growth and expansion which will create millions of jobs and great wealth and any of these companies could become part of your portfolio in the future. We don’t generally recommend IPOs because they frequently experience extreme volatility, but we do follow new companies as they come to market and gauge investor enthusiasm. Long term, IPOs and disruptive technologies will influence our investment thesis and the stocks we own in these emerging sectors.

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Contact Peter

All of us at Karp Capital Management thank you for your continued support. It is a privilege to help you, your family and friends reach financial goals. We’re flattered when you refer your family, friends and colleagues. 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/news.

If you have any questions on the preceding analysis, or would like to review your portfolio’s performance, please call me 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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