Karp Capital Management Focus
1st Quarter Report
Written by Peter Karp
April, 2014

The Financial World is Also a Stage

The Financial World and the Weather

Markets have vacillated for much of the first quarter as severe winter weather in the United States has undermined economic momentum. Additionally, investors wonder about the pace at which U.S. interest rates will rise now that Janet Yellen has assumed the role of Fed Chair. Concerns about emerging economies and the speed of recovery in Europe kept investors on edge. The fragility of the financial markets of the developed world is obvious as nerves are frayed over Japan's ability to withstand a sales tax increase and its expansionary monetary policy (easy money). China's slow growth has spooked world markets. Though China has had some success cutting export and investment-oriented expenses, the Chinese consumer has not picked up the slack. Despite the headwinds we’ve seen, more investors flocked to riskier stocks and increased their willingness to pay higher prices for growth. We think investors should proceed with caution when adding growth holdings to portfolios. We are concerned by the mergers and acquisition appetite in the technology sector. The two recent company purchases by Mark Zuckerberg of Facebook set off alarms. Oculus was paid $400M in cash and another $1.6B in Facebook’s (FB) stock. The powers-that-be at FB used its inflated stock price as currency to pay an inflated price for Oculus. Technology is a wonderful thing, especially if you are the investment banker brokering the deal. When you compare it to the makers of Candy Crush that went public with an IPO valued at $7B it looks like the guys at FB got a good deal. Does anyone remember the tech bubble of 2000? The companies are different but the story sounds familiar. We choose to buy investments following our investment premise of inflation rising and U.S. growth slowing. The investments and sectors tied to accelerating inflation include soft agriculture commodities and countries that base their exports on commodities and basic materials. The investment sectors that fit the slow growth thesis are utilities, REITS and long term treasury and high grade corporate bonds. In this edition of Karp Capital Focus we outline how to survive a market and economy that is in transition.

In This Issue:

The Financial World is Also a Stage

Market Performance

Look Who's Blaming the Weather

China, Real Estate and The Bay Area

Corn – Sugar – Wheat, and all That Glitters

Will I Make Money in the Stock Market this Year?

Beware of the Market's Achilles Heel

How Does Tax Free Income Sound?

There’s No ‘There’ There

The Truth About Wall Street Firms Shouldn't Surprise You

Do You Have an Exit Planner?

Successfully Managing Tangible Assets

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Market Performance

Here are the performance numbers for the major indices as of 3/31/2014 (Total Return):

March
2014

Latest
3 Months
Latest
6 Months
2013
% Change
Dow Jones Industrials
0.93%
-0.15%
10.03%
29.65%
Standard & Poor’s 500
0.84%
1.81%
12.51%
32.39%
NASDAQ Composite
-2.45%
0.84%
12.07%
40.16%
Russell 2000
-0.68%
1.12%
9.94%
38.82%
MSCI EAFE
0.57%
0.77%
6.56%
27.46%
Long Term Treasury Bonds
0.74%
7.41%
4.05%
-13.29%
Gold
-2.62%
7.45%
-2.62%
-27.79%
Bonds outperformed stocks in the first quarter, with long term treasuries outperforming the S&P 500 by about 6%. First quarter sector leaders were Utilities (+9%) and Health Care (+5.4%), followed by materials (+2.3%), and Financials (+2.2%). The Consumer Discretionary sector was the biggest loser declining 3.2% during the quarter. Outside the U.S., developed markets declined slightly while emerging markets gained 3%. Latin America was the best performer, gaining 8%, driven by strong performance in Brazil, Mexico and Colombia. As of 03/31/2014, the S&P 500 has gone 909 days without a 10% or greater drop in the index, the 5th longest stretch without a double-digit pullback in the last 50 years.
Sources : Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML, Internal Revenue Service. Stock market indices do not include reinvested dividends.



Look Who's Blaming the Weather

California DroughtU.S. investors have largely ignored geopolitical worries and lackluster economic numbers pushing stocks to record highs. The overall sentiment is that economic figures have been good enough to keep the major indices close to record high levels. The impact of January and February’s severe weather has been singled out by economic pundits as a major cause for weak economic activity. We believe the larger drag on economic growth will be the continued drought in the western United States. Food prices and industries associated with moving agriculture to market will stagnate growth. Moreover any industry that uses water will feel the effects from water rationing and price increases.

U.S. economic data in the first quarter of 2014 was largely disappointing with vehicle sales, housing activity and industrial production falling short of estimates. Investors should remember that even growth as low as 2% should be sufficient to reduce unemployment and boost wages. This is why we believe the focus by the Federal Reserve and Janet Yellen on the unemployment rate is like looking at the hole of a donut. For a better understanding of the employment numbers you must go beyond the headlines to the components of the jobs report. The participation rate has been trending lower due in part to the unemployed being under reported in the official numbers. We are therefore cautious about the near-term outlook for the economy and markets.

Yellen-The FedWith the conflict between Russia and Ukraine and civil unrest in Venezuela, oil prices and energy costs are likely to move higher, or at least remain elevated. History shows that these situations are temporary, and the market tends to move on quickly to new concerns. The markets have been resilient, though some sectors are starting to show signs of fatigue. The Fed should continue to keep rates low, even as it withdraws quantitative stimulus. Earnings expectations should continue to move upward as the U.S. and developed markets continue their economic recovery albeit slower than 2013. We do see the events in Eastern Europe as a potential obstacle for the markets. The outcome in Ukraine is impossible to foresee and uncertainty can increase volatility, coupled with China’s slowdown. These are some of the events and trends that drive the asset allocation for the portfolios managed at Karp Capital.

China, Real Estate and The Bay Area

The troubling news out of China could have a big impact on the Bay Area's hot housing market. The U.S. stock market took in stride China's slowing retail sales, tighter credit and other signs of a softening economy. Pockets of economic weakness in China emerged, as the collapse of a highly indebted real estate developer and weak home sales suggest a slowdown in the sprawling property sector. Shanghai Chaori Solar Energy is China’s first mainland bond default. Some see a situation similar to the U.S. financial crisis unfolding. China’s rapid growth in lending outside its traditional banking system could temper San Francisco's hot real estate market. The Chinese Central Bank is starting to guide their currency (yuan) lower by easing monetary policy. The resulting liquidity will keep more money in China and less money will be invested in the overseas real estate market. Major cities in the U.S. (San Francisco in particular) have been safe havens and easy places to purchase real estate.

Corn – Sugar – Wheat, and All That Glitters

We believe the time is right to tap commodities as a unique source of returns, diversification and protection from unanticipated inflation. The commodity universe has just completed one of its strongest quarters in the last 5 years. Commodities have fallen out of favor in recent years and we have certainly been negative on the sector, however, it’s starting to look as if we’ve turned an important corner. We’ve been adding gold and agriculture commodities to our clients’ portfolios choosing to be early to the party. Over the last few years the U.S. economy has not experienced inflationary pressures but the markets and Main Street are beginning to paint a different picture. Commodities can hedge against inflation and serve to increase returns because prices are driven by factors beyond traditional asset classes. A portfolio that includes commodities is potentially more diversified and likely to have a better risk-adjusted return than one concentrated in stocks, bonds and real estate. Moreover, inflation may be more of a risk in the longer term as a result of a pickup in bank lending and the continued central banks’ accommodative monetary policies.

Will I Make Money in the Stock Market This Year?

Stimulus AnniversaryIn March we observed the fifth anniversary of the U.S. equity bull market, which started after the S&P 500 Index bottomed in March 2009. With events in Ukraine, the crisis in Syria and a stalemate with Iran, attention was diverted from domestic to foreign issues in Washington. Are we on track for another year of stock gains, or have we reached the top? There are issues in certain sectors that indicate a top in the market is forming. Overall major market indices seem to be fairly valued. If we compare valuation metrics today with the two previous market peaks, it is evident that the private sector is in much better shape this time around. Earnings per share (EPS) are notably higher, while the trailing price-to-earnings or P/E ratio of the market is not yet at the levels we saw at the tech bubble’s peak in March 2000 or even in the not-so-bubbly October 2007. What about indicators that look ahead, rather than behind? If we consider the forward P/E based on analysts’ estimates of earnings over the next 12 months, we find the market fairly valued.

We believe analyst expectations are too high for some sectors. The markets are signaling a rotation from low-quality, high-growth companies to high-quality defensive sectors. Credit markets are indicators of where stocks might go as well. One way to gauge where the stock market is heading is to watch corporate bond interest rates in relation to treasury yields as they react to disruptive global events.

Beware the Market's Achilles Heel

After the magnificent returns of 2013, investors and market experts are naturally asking if the market has topped and a correction is in the works. The bullish majority believes stock prices will rise in response to faster U.S. growth, while the bearish minority expects disappointing growth to drag stocks lower. Although some wild card event may be the catalyst for a correction, rising inflation will be the true Achilles heel of the markets. Over the past few years stagnant wages have kept inflation dormant and bolstered corporate profits. Despite a weather-depressed economy, hourly wages have started to rise (a primary driver of inflation). Fueling these trends is the recent turn in bank loans. Banks are sitting on $2.5 trillion in excess reserves. Banks are over capitalized mainly because of regulation. Even under restrictive banking rules, these reserves provide an abundance of rocket fuel for new credit. Banks are desperate to expand their lending. Combine this with record high household net worth and better hiring conditions and growth is a likely outcome.

The demand for skilled labor is at a five-year high and supply at a five-year low. This will help the middle class as income transfers from corporations to the consumer. Faster growth and rising inflation would force the Fed to accelerate the tapering process currently underway. Rising interest rates are not necessarily bad for stock prices; it can signal an improving domestic economy.The markets haven’t fully recognized the subtle shift from inflation in financial asset prices to inflation in the real economy currently under way. We see 2014 as a transition year changing our focus sectors and asset allocation in order to drive favorable risk-adjusted performance.

How Does Tax Free Income Sound?

The strong performance of the municipal market so far in 2014 is partly a response to how cheap that market had become at the end of last year. At the end of 2013 we stressed that we were looking for tax free income and not shying away from building a municipal bond portfolio. So far municipal bonds are one of the top performing sectors this year. As an asset manager we look for favorable reward vs risk. Headlines will always create turbulence in the markets; however we will try to filter the tsunami of information to focus on the trends that will position our high net-worth clients with the best growth and income prospects for the long term. Investors are realizing that tax free income is hard to come by and so municipal bonds are quite attractive. Investors are concerned that interest rates will rise, but an increase in interest rates may actually improve pension funding status. If interest rates go up, those huge buckets of investments will see better returns and shore up the pension system without the public’s bailout. Because of such factors, high yield municipal bonds could lead bond market performance as we head into spring.

There's No 'There' There

The BubbleThe first quarter of 2014 wasn’t much of a show, with the S&P 500 going nowhere and now hanging onto positive territory by a thread. The beaten down technology, biotech and momentum stocks at the end of the quarter were a telling story as far as the direction of the economy. We are not predicting a lost year for stock indices but we are not terribly surprised that a quarter has just passed us by without the major stock indices moving higher. It should be noted that the major U.S. indices have not suffered any deep declines either. From April through October we will focus on high quality, defensive sectors: utilities, consumer staples, banks, commodities and large cap technology. High quality stocks posted bigger profit margins and have incurred less volatility during the last quarter. After managing money during the first internet bubble (1999), then the real estate bubble (2005-2006), then the commodity bubble (2011-2012), then the bond bubble (2011-2012), and now the half-baked internet bubble, we are sensitive to avoiding asset minefields. The utility index has been the best performing sector in 2014. Its defensive nature makes it an unlikely candidate for bull market leadership but it still has upside as we head into the spring and summer months. The second best performing sector is the big banks. This group would benefit from rising short term interest rates, since they would expand lending margins. Since we believe the long end of the yield curve will remain stable, the interest rate environment is conducive to earnings expanding significantly from the current level.

The Truth About Wall Street Firms Shouldn't Surprise You

This past quarter we were entrusted with managing assets for new clients. These new clients were introduced by existing clients and other professionals who understand that we treat our clients as teammates and see our role as an advocate, representative, and interpreter within an increasingly complex investment world. Unfortunately too many people think that Wall Street firms are there to provide investors with good advice designed to help them reach their financial goals. Over and over we see the portfolios and hear the stories… investors do not get what they want from their advisors. People want straightforward advice and a customized portfolio. There is a long way to go until investors’ objectives and those of their Wall Street brokers align. At the major brokerage firms it is commonplace for an advisor or broker to be rated based primarily on the revenue brought to the firm, not how well they do for their clients. There is an obvious disconnect between the needs of the client and the way those needs are being addressed. The clients of Karp Capital Management have a unique experience. Your success is our success. Let us help you reach your financial goals. We look forward to your feedback on our service, products and guidance.

Do You Have an Exit Planner?

An exit planning advisor provides solutions to business owners who are about to make one of the most important financial decisions of their life —the exit from their business. Most of a privately held business owner’s wealth is tied to their business. Exit planners help small business owners determine how to convert their illiquid asset to liquid while protecting their wealth and business for generations to come. The baby boom generation is nearing retirement. Exiting business owners need to prepare and adapt an exit strategy in order to exit their business in an increasingly competitive marketplace. Interest rates are still near historic lows and cash is readily available for business financing. Many traditional merger and acquisitions (M&A) practitioners are seeing the benefits of partnering with those who specialize in exit planning. The hope is to bring the two worlds of exit planning and M&A together for a mutually beneficial collaboration and to better serve the exiting owner in an effective and comprehensive manner. If you have been contemplating an exit from the company you own, give us a call and let’s start the conversation. We have the resources and experience to guide you and your executive team.

Successfully Managing Tangible Assets

Tangible AssetsRecent record-setting auction house sales prices—$83 million for the Pink Star diamond and $142 million for Francis Bacon's Three Studies of Lucian Freud—have returned attention to valuable collections as a potentially rewarding asset class. In recent years, tangible assets such as fine art, wine, jewelry, antiques, sports memorabilia and classic cars have finally been recognized as an asset class. Collectors rarely apply the same rigor to these items when making investments or business decisions. Collectors can only sufficiently protect their wealth if they and their advisors have access to a comprehensive view of their tangible assets. Here are six steps to managing the complex and evolving set of risks associated with this increasingly important asset class. If you own tangible assets or a collection and you would like to discuss how it fits into your financial plan, please give us a call.

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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.