Karp Capital Management Focus
4th Quarter Report
Written by Peter Karp
January, 2014

Year of the Roller Coaster

The Road Ahead

The second half of 2013 was tumultuous for the markets after the Federal Reserve hinted that it would soon start scaling back on stimulus measures. Investors initially reacted with fear, but as volatility subsided, the bull trend resumed with full force. Many market participants were prompted to rotate out of defensive equities and into growth sensitive, cyclical equities. Around the world, we saw a return to economic growth in Europe and stabilization in the Chinese economy. Talks with Iran on its nuclear program appear to have reduced the probability of an Iranian disruption to the global oil market and therefore the global economy. Financial markets have responded to these developments by bidding up the value of riskier assets. U.S. stocks posted strong gains while traditional safe havens such as treasury bonds and gold slid. Major U.S. equity benchmarks finished off the year near all-time highs. The financial establishment is shy about being too optimistic on the economy but it’s difficult to believe that GDP numbers for Q4/2013 will be weak. Gains in employment are likely to spur consumer confidence and should be evident in the holiday sales numbers. 2013 will be remembered for diminishing uncertainty and rising markets. In Washington, a late-year bipartisan budget agreement eased the pain felt earlier in the year by the fiscal cliff, the sequester, a partial government shutdown and finally a disastrous rollout of the Affordable Care Act (ACA). The underlying fundamentals of the economy are improving and growth in the economy has been enough to overcome the problems that cropped up along the way.  Whether the market can grind higher in 2014 is THE question. The impact of the ACA could be enough to deal a blow to consumer spending, but it's too early to forecast how it will play out. The economy has powered through a payroll tax hike, proving that economists were wrong in their forecast of stifled economic growth. In this installment of Karp Capital Focus we will give our perspectives on the implications of Fed policy for global markets, what rising rates could mean for U.S. equity markets and how we intend to position our clients’ assets.

In This Issue:

Year of the Roller Coaster

Market Performance

Holiday Spirit at the Federal Reserve

China

Housing

As Good as Gold

Investment Focus - Energy and the USA

Where do we go from here?

Bond Wasteland

Retirement Plans at Risk

Are you Ready for Retirement?

Time to give back

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Market Performance

Here are the performance numbers for the major indices as of 12/31/2013: (Total Return)

Latest
1 Month

Latest
3 Months
2012
% Change
2013
% Change
The
Close
Dow Jones Industrials
3.18%
10.20%
10.23%
29.65%
16,577
Standard & Poor’s 500
2.53%
10.51%
16.00%
32.39%
1,848
NASDAQ Composite
2.97%
11.13%
17.74%
40.16%
4,177
Russell 2000
1.97%
8.73%
16.35%
38.82%
1,164
MSCI EAFE
1.41%
6.40%
17.89%
27.46%
1,916
Long Term Treasury Bonds
-1.97%
-3.13%
3.54%
-13.29%
 
Gold
-4.11%
-9.42%
5.68%
-27.79%
$1,197
During 2013 both the Dow Jones Industrial Average and the S&P 500 broke numerous records. Smaller cap companies fared even better in 2013. Both the S&P MidCap 400 and S&P Small Cap 600 outperformed the S&P 500. Every sector of the S&P 500 gained more than 10% for the year. Consumer discretionary, health care and industrials were the top performers while the defensive sectors, utilities and telecom services were at the bottom. International equity markets had ups and downs. Developed markets gained 21% but emerging markets dropped 1%. Bond yields rose in 2013. The S&P 20+Yr U.S. Treasury index declined 14%. Commodities performed poorly in 2013. The Dow Jones Commodity index dropped by 10%.
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.



Holiday Spirit at the Federal Reserve

What gift is most favored among investors? Answer…CERTAINTY. The Fed delivered an early holiday surprise announcing at its December 18th policy meeting it would start slowing its asset purchase program known as Quantitative Easing (QE). The current $85 billion will be cut to $75 billion as a prelude to winding down the program completely in 2014. With strong economic numbers and a budget deal adding up to gains in the stock market, Fed Reserve officials knew they had a delicate decision to make. The logical step was to pull back on their bond-buying program. Ben Bernanke had learned from the error of his ways during Q3 when each day it seemed that the story changed, taper on vs. taper off, and that uncertainty drove investors to sell equities as yields spiked. In September 2012, QE3 was a pre-emptive strike by the Fed to protect the economy from our politicians. Ultimately, the worst effects of the fiscal cliff were averted by an 11th hour agreement that raised taxes and cut spending. Now that a two-year budget agreement has been reached, the Fed can wind down QE3. With the outlook more certain, the insurance policy is no longer needed. The first and second round of QE functioned to restore the credit markets and facilitate lending. During QE3 most of the new money created when the Fed bought more than $1 trillion worth of bonds just remained at the Fed as reserves. The bulk of the money was not lent out, nor invested, nor spent; it just sat idle. Fed researchers have calculated that $1 trillion of QE drives down 10-year Treasury yields by ¼%- ½%. In other words, it takes a lot of purchases to suppress rates a little. This did help the mortgage markets as people rushed to refinance, lowering their expenses and paying down debt. We are now seeing leadership by the Fed.  Setting the tone builds confidence and allows businesses and individuals to make financial borrowing and buying decisions with conviction. The actual size of the taper, $10 billion, is trivial as the Federal Reserve is still aggressively implementing its unorthodox policy. There is no refuting this is a change in direction after 6½ years of easing monetary policy and so makes it momentous.

China

China GrowthIn early 2013 we were bullish on China, and then our enthusiasm faded. There were structural changes that needed to occur in order to see stock prices move higher. We have witnessed those changes and we are back on the China horse as 2014 begins (the year of the horse). China did not have the hard landing that most market pundits feared in 2013. Rather, economic growth is stabilizing. It now appears the economy will meet its 2013 growth target of 7.5%. China can afford to grow at a slower rate than in the past without damaging employment and wage growth given the economy is not just relying on exports. Also, the reforms agreed to at the government’s policy setting meeting in November are far reaching. They aim to strengthen the market-based economy and potentially change the economic role of the government. Land reforms and the easing of China’s one-child policy should support China’s move toward a consumption oriented, rather than an investment led, economy. In the near term, Chinese growth could slow as support from housing and infrastructure investments fades and as the overheated housing market and banking system issues are corrected. Chinese President Xi Jinping and First Lady Peng Liyuan are ushering in a Camelot era for China. Similar to the Kennedys, the couple symbolizes the economic and ever-advancing strength of the country. First Lady Peng is very familiar with the limelight, as she was once more famous than her husband, singing patriotic songs in the People’s Liberation Army. She is very different from previous Chinese first ladies, who were typically invisible to the rest of the world. As the world gets to know her, the first lady will likely broaden the appeal of China. Looking ahead, with the support of new leaders, Xi appears to have the confidence and backing to put in place reforms that could position China on a multiyear growth trajectory. As long as policymakers follow through with reforms and keep credit conditions tight, Chinese stock valuations should benefit. There are still risks but we want to be where there are growth opportunities and Chinese equities are inexpensive given the growth prospects.

Housing

Housing start numbers were very strong for the month of November with estimated starts ahead of all published forecasts and the highest level in over five years. The data suggest a new uptick in activity that supports our housing thesis from previous newsletters. Single family permits rose to the highest level since April 2008 supporting the notion that activity is ramping up in this key portion of the U.S. economy. Investors have been worried about rising rates and the effects on home sales; we are not worried. The banks are re-positioning their loan portfolios. Borrowing rates will stay low but borrowers must be alert. As in past periods of rising rate expectations, short term adjustable rate mortgages (ARMs) are starting to replace 30 year fixed rate mortgages. Continued improvement in household wealth bodes well for future consumption, as individuals tend to spend more when they feel wealthier and fiscal drag subsides. As consumer confidence recovers, home ownership is still enticing. The inventory of unsold new homes has been worked off and construction is below the level required to house a growing population. In our last newsletter we were somewhat early in making the U.S. Home Construction Index a focus sector, but now it’s paying off for our clients. Rate sensitive sectors were hurt by the increase in interest rates during much of the second half of 2013.

As Good as Gold

Gold PriceGold prices look like they have made what is known as a double bottom in the wake of the Fed's taper decision, bouncing off the lows of late June. This is a critical technical level for gold because a push to a new low will unleash a new wave of selling. Gold is unlikely to fall much further because gold mines are already cutting production or closing, but the drop in prices have been accompanied by heavy physical buying in Asia. There are roughly 100 times as many financial ounces of gold in the market as physical ounces, allowing sellers to overwhelm physical buying. There are scenarios in which gold could continue falling, but it would probably require some extreme economic outcomes because Chinese and Indian demand for the physical metal remains robust. A major drop in demand would require an economic disaster in China. At this time, we are adding exposure to gold through a gold mining index ETF to our portfolios given the uncorrelated nature of the sector to most of the other traditional asset classes we use in our clients’ core portfolios. Call us to see how adding alternative investments lowers the risk and volatility of your portfolio.

Investment Focus - Energy and the USA

As the new year begins, we reflect on trends that have attracted capital and the prospects for above average returns relative to the market. This helps guide us to sectors we may overweight in our clients’ portfolios. One of the biggest opportunities we see is U.S. energy resurgence and its implications for oil and gas stocks. Only a few years ago, we were contemplating the supply constraints facing the petroleum industry, as many major oil fields around the world were facing a decline in production. Energy technology is altering the face of the industry, opening up new opportunities across the spectrum from exploration to production to infrastructure. With the disruptive technology called hydraulic fracturing (aka fracking) used to extract oil and gas from shale deposits, we may be looking forward to decades of drilling. Forbes reported that the American hydrocarbon energy boom is driving a massive resurgence in domestic manufacturing. The U.S. is the world’s fastest growing and now number one producer of oil and natural gas in the world. America is now a net exporter of manufactured gasoline and diesel for the first time since 1949. Demand for OPEC crude could fall by a million barrels per day within five years. Regarding the domestic production of oil, most of the growth has been in Texas, Montana and North Dakota. America’s ingenuity and success in extracting its oil and gas resources certainly seems unique. Even though shale areas are found around the world in Australia, Turkey, Russia and China, the U.S. is expected to supply the majority of light tight oil (LTO) to the world through 2035, as other countries struggle to replicate the U.S. extraction method. We have identified technology companies and oil and gas sub sectors that will be direct benefactors of this multi-year energy boom for inclusion in our clients’ portfolios.

Where do we go from here?

In 2013 buying on any dip was a winning strategy. Although stocks in 2014 might not provide returns as high as those during 2013, the U.S. stock market’s return might be above average in 2014. Are the fundamentals of the market and stock prices aligned? It makes sense to be positive on equities when they are cheap and earnings are likely to surprise significantly on the upside. These days few sectors look cheap and the market environment is increasingly becoming a stock pickers market. Several indicators can provide advance notice of trouble ahead. These include measures of monetary conditions, valuation and the technical backdrop. There is no easy way to predict the direction of the markets but we are sensitive to changes in the economic and/or policy background that threaten to reverse the stock market price uptrend. Moving the U.S. and global economies onto a sounder foundation, where rising incomes lead to increased spending is no easy achievement. The corporate sector shows no sign of easing up on its tight grip on costs and we should expect wage gains to be kept as low as possible. The question remains how long the corporate sector prospers while Main Street is still hurting from the last recession. Consumer incomes and spending will benefit from steadily rising employment and business investment should increase as corporate confidence builds. The best may be over in terms of the rate of appreciation in the U.S. equity market, but that does not mean the recovery has ended. There are various pockets of growth at work such as the domestic housing market and the oil and gas boom. We favor investment in stocks and sectors that are leveraged to economic growth and avoid sectors that do poorly when bond yields rise. We are emphasizing investments in capital spending rather than consumption. We recommend overweighting industrials, technology and financials and underweighting utilities and telecommunications services. Outside the U.S. we are increasing our equity exposure in Europe. The European economic recovery lagged the U.S. during the last cycle, but smaller capitalized European stocks are an emerging sector that currently has the world’s strongest 12-month earnings growth forecast. Few investors seem aware of these superior growth prospects and we are looking to capitalize on this opportunity.

Bond Wasteland

One of the consistent narratives promulgated in this recovery is the apparent disconnect between economic growth and corporate profitability. U.S. corporate profits per employee have soared to all-time highs. Furthermore, corporate America has benefited from an easy monetary policy. In December corporations issued more bonds than ever before. Total sales of dollar-denominated corporate bonds amounted to approximately $1.482 trillion, beating last year's record high of $1.479 trillion. Corporate bonds, overall, are yielding about 2% more than comparable U.S. Treasuries. That difference (spread) is essentially the premium investors require to hold corporate bonds over comparable Treasuries. The current difference is the smallest since October 2007. There is an insatiable appetite for investment income and with interest rates still near their lows, investors are desperate for yield. With companies issuing more bonds than ever the volume of new high-yield bonds flooding into the market is also at a record high. High-yield (junk) bonds – those rated below Baa3 by Moody’s and BBB by Standard & Poor's – are issued by riskier companies. These companies pay more interest to compensate investors for the higher default risk. You cannot justify a 5% yield on a junk bond mathematically. If you factor in the default rate with inflation, you cannot possibly make a positive real return buying junk bonds with a yield of 5% or less. Yet we're still seeing it happen. It makes no sense. At Karp Capital we have decided on a higher allocation of cash and dramatically under-weight bonds. Cash has zero correlation to other investment classes so no principal fluctuation. Keep in mind bond risk could be as severe as equity risk when poor fundamentals are in play.

Retirement Plans at Risk

113th CongressIRAs are a vital component of U.S. retirement savings, representing more than 25% of all retirement assets in the nation. A substantial portion of these IRA assets originated in employment-based retirement plans, including Defined Benefit, Profit Sharing and 401(k) Plans. These corporate retirement programs are currently a focus of our legislators as they shore up their own retirement plan benefits. Congressional tax cuts are a real threat that may affect retirement plans. Congress is considering tax reform that could result in reduced retirement plan contributions (in order to increase tax revenue). This would be devastating to small and midsize business owners and their employees’ potential retirement plan savings. Last time Congress made major changes to the tax code, they reduced the level of permissible 401(k) contributions by 70 percent. A campaign called Save My 401(k) has been launched by the American Society of Pension Professionals and Actuaries (ASPPA) to defend the 401(k) and other qualified retirement plans against these potential Congressional cuts. The campaign aims to educate Congress on the benefits of retirement plans as they begin the debate on tax reform. If you wish to participate by sending a pre-written letter to your representative in congress, simply visit www.savemy401k.com. After completing a few fields, the automated system will send an e-mail asking that Congress… Stay away from my 401(k). As a reminder, it is financially prudent to take full advantage of the tax savings vehicles we have at our disposal. For a list of the 2014 cost-of-living adjustments (COLA) for qualified plans (401(k), 403(b), Profit Sharing and Defined Benefit Plans), click here.

Are you Ready for Retirement?

The number one question that arises during a comprehensive client review is… can I retire? Retirement takes many different forms so the answer is never a simple yes or no. First we must understand what retirement means to each client and answer these questions...

  • When can I retire?
  • Can I maintain or improve my current lifestyle?
  • Am I covered for unexpected expenses?
  • What can I leave for my heirs and/or favorite charities?
  • What happens if there’s another financial crisis?

Because retirement readiness is core to any financial plan, we spend a significant amount of time on the topic with each client early in the relationship and revisit it regularly before and after retirement occurs. Retirement is less an event than a process. Many people choose to work part time during their golden years, either in their same professions or in new ones. Such changes in the nature of retirement make analysis that much more complex. Stopping all gainful employment still happens but it is becoming less common. With so many unknowns, analyzing retirement readiness goes well beyond simple arithmetic. It’s no longer about plugging numbers into a calculator (retirement earnings multiplied by rate of return minus expenses). At best, this approach will be only a rough approximation; at worst, it will give a false sense of security. A technique that increases the usefulness of retirement analysis is the Monte Carlo method. The Monte Carlo technique creates multiple iterations of a particular retirement scenario and yields a likelihood of success. The Monte Carlo Simulation produces a success rate between 0 and 100 that represents the percentage of simulations that were at or above goal (not running out of money before the end of the projected lifespan). A success rate between 70 and 90 is considered ideal. Call us if you would like us to determine your success rate.

Time to give back

Inheritance TaxCharitable giving is not a new concept but through the financial crisis and economic recovery, charities have had a rough time and the need is ever growing. The equity markets have created tremendous wealth for people over the last couple of years. Now is the time to give back. There’s nothing new in philanthropy, but the basic standbys come back into favor with improving economic times. As we start the new year it’s a perfect time to incorporate your favorite charity into your investment and estate plan. Tapping into your philanthropic side is good for society and your soul. In addition, charitable giving can significantly reduce your tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts. From a tax-planning perspective, appreciated securities are now a viable strategy given the substantial market gains. Another tax-favored technique with renewed interest is the charitable remainder trust. A CRT allows the donor to benefit a charity and benefit him/herself or a family member with annual payments from the trust for up to 20 years or the lives of the beneficiaries. At the end of the term, remaining assets are distributed to one or more qualified charities. A CRT is very attractive to charitable minded people with highly appreciated assets. An important feature of a CRT is that when the appreciated assets are sold to start the trust, the capital gains tax is deferred, making it useful for a donor who wants to diversify an asset and then derive income from it. As each distribution is made to a non-charitable beneficiary, it is included in that person’s income. A CRT doesn’t avoid tax on capital gains, but merely defers it until distributed. At the same time, the vehicle allows all proceeds from a sale by a CRT of an appreciated asset to be invested and grow rather than having to pay the capital gains tax in the year of the sale. Depending on the amount of gains and amount of other income, it could be a very long time before they’re all fully paid out or until any are paid out at all. Karp Capital is able to manage your CRT for you as part of your overall investment program. People are philanthropic for many reasons, but it generally comes down to values. Tax efficient giving makes sense… you give more to charity and save more money. In addition, working together on a philanthropic project can help parents teach their children about the family’s wealth and how it can profitably and charitably be put to work. Give us a call if you are inclined to pay it forward.

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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 www.karpcapital.com.

If you have any questions on the analysis above, or would like to review your portfolio's performance, please call me at 877-900-Karp. Working with Karp Capital, there is only one boss, YOU!

Peter Karp
Peter Karp

Karp Capital Management Corporation
Registered Investment Advisor

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

Office Address: 188 The Embarcadero
San Francisco, CA 94105

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 and income arising there from can fall as well as rise; the investor may get back less than what was invested; and no assurance can be given that any portfolio or investment described herein would yield favorable investment results. We or our associated persons may act upon or use material in this report prior to publication. This document may not be reproduced or circulated without our written authority.Securities offered though Financial Telesis Inc. member FINRA/SIPC. Karp Capital Management is not an affiliate of Financial Telesis Inc.