Karp Capital Management Focus

3rd Quarter Report

Written by Peter Karp
October, 2014

Are We at an Economic Turning Point?

European Drain

Geopolitical tensions continued to grab headlines during the third quarter of 2014. For investors this was offset by continued signs of U.S. economic recovery and the prospect of further stimulus against a backdrop of lackluster economic conditions in the euro zone. Manufacturing numbers came in below expectations with weakness in the economies of Germany, France, and Italy. At the annual Jackson Hole Conference of Central Banks, Mario Draghi (President of the European Central Bank) announced that he would “keep the policy stance accommodative for an extended period of time,” and so negative returns were erased from the first part of the quarter for international equities, though volatility increased. On the surface, things appear to be picking up in the U.S. The contrast in economic conditions between the U.S. and much of the rest of the world is likely to continue to draw more investment to the United States in the near-term. Any further geopolitical flare-ups are also likely to contribute to the attractiveness of U.S. treasuries and support lower interest rates in the U.S. allowing the Fed more flexibility for its exit strategy.

The recent record performance of the S&P 500 is painting an incomplete picture. Roughly 45% of stocks in the NASDAQ and Russell 2000 Indices are experiencing a bear market. The divergence between large-cap and small-cap stocks highlights significant threats to the market, painting a darker picture for near-term performance. Higher bond yields and the continuing strength of the dollar provide more reasons for foreign investors to favor the U.S. After years of quantitative easing, the dollar is finally starting to strengthen with positive economic indicators and expectations for the Fed to raise interest rates. In the last three months the U.S. Dollar Index has risen over 7% while the Dow grew by less than two percent. This move has had direct implications on the price of gold and oil. Investors aren’t retreating to gold to protect the value of their assets, driving down the price of gold to multi-year lows. The price of oil is hovering near $90 a barrel. With a stronger dollar and cheaper oil, we may see an increase in consumer spending.

Consumers will have more buying power with the same amount of dollars for spending on discretionary items, driving up corporate sales and revenue. Foreign firms have the advantage of increased output when the dollar buys more goods when converted to that country’s currency. We maintain a strong European allocation to take advantage of this dollar spread. We have yet to see incomes rise which would make consumers more confident in the durability of the economic recovery. This supports our outlook for continued low inflation in the near-term. We are still waiting for more positive consumer sentiment to help spur a key laggard… capital spending. Companies have been hoarding cash at unprecedented levels rather than investing in new business activities.

In This Issue:

Are We at an Economic Turning Point?

Market Performance

What's Next?

Doing the Right Thing

Implications for Stocks – Nothing to Fear but Fear Itself

Election Primer – Does It Matter?

Income for a Lifetime

Are You Prepared?

Managing Money

Supporting Effective Charities

What We can Learn from a Chinese Billionaire

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Market Performance

Here are the performance numbers for the major indices as of 9/30/2014:

Latest
1 Month

Latest
3 Months
YTD

Latest
12 Months
Dow Jones Industrials
-0.23%
1.87%
4.58%
15.25%
Standard & Poor’s 500
-1.40%
1.13%
8.34%
19.73%
NASDAQ Composite
-1.81%
2.24%
8.58%
20.67%
Russell 2000
-6.05%
-7.36%
-4.41%
3.93%
MSCI EAFE
0.19%
0.98%
4.49%
11.18%
Long Term Treasury Bonds
-1.95%
2.83%
15.83%
12.20%
Gold
-5.39%
-7.49%
1.25%
-8.29%
VIX (Volitility Index)
36.14%
40.97%
18.88%
-1.75%
The latest correction has occurred with the volatility index soaring 40% in Q3. Treasury bonds were the best performing asset class in Q3, +2.8% beating U.S. Stocks +1.1%, rest of the world equities +.9% and Gold was the worst performer with a return of -7.4%. The Health Care sector was the best performer year to date +5.0%. Tech was the second best performing sector +4.8%, where owning Apple Computer (AAPL) was paramount. AAPL contributed one-fourth of the S&P 500’s total return for the past quarter.
Sources : Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML.
Absolute price return. Stock market indices do not include reinvested dividends.



What's Next?

The sell-off of expensive stocks hasn't hurt the broader market… yet. The largest market cap stocks of the S&P 500 haven't fallen yet; they probably won't until the corporate bond market starts to fall. Institutional investors constantly evaluate whether to own more stocks or more bonds. Much of their decision making is driven by what they can earn in bonds. When corporate bonds offer relatively high yields (8%-10%) annually, institutional investors will opt to sell stocks and buy bonds. Doing so allows them to lock in gains and earn relatively high returns on their capital, with much less risk. Remember, bond prices move in the opposite direction from their yields. So a big fall in bond prices would send yields soaring. Higher interest rates will initially drive down stock prices. The Federal Reserve's bond buying has kept the corporate bond market strong. Buyers seeking yields of more than 4% have been forced into the corporate bond market and further out on the risk spectrum. Pension funds have been locking in the equity gains of 2013 and rebalancing holdings towards fixed income. Risks to economic growth have materialized over the past few months. More and more investors have decided to buy government bonds to avoid credit risk. This has forced the benchmark interest rate in the U.S. (the 10-year Treasury note) back to around 2.5%. Rates this low indicate that many bond investors fear the U.S. economy could dip back into a recession over the next year. In the short term this is a concern and needs to be watched closely. In the pursuit of additional yield, we prefer municipal bonds. We also like high grade corporate bonds, utilities, preferred stock and long term treasuries for income oriented investors.

Doing the Right Thing

During bull markets it's easy to forget just how fast the party can end. Complacency can easily find its way into investment decisions. Then, out of the blue a wake-up call comes. Overnight, we are reminded that the markets don't always go straight up. We’ve been conditioned by Wall Street to believe that over the long haul, stocks do in fact go up. That is an undeniable fact. But when asked about the intermediate-term, we're told that there's no way of knowing which direction the market will go and the best option is to stay fully invested. We're told to just sit tight and ride it out. At Karp Capital we use indicators that tell us when to take our foot off the accelerator. We are constantly hedging our clients’ portfolios and adjusting the asset allocation to assume lower market risk. Like it or not, we're in a new investing environment that could be with us for years. By following a rules-based methodology we are able to capture much of the upside in a bull market. When markets start to roll over as we began seeing in August we can reallocate and hedge. By using a proper mix of strategic and tactical/alternative strategies we decrease the downside risk in the portfolios we manage.

Implications for Stocks – Nothing to Fear but Fear Itself

There is a sweet spot for equity investors. The stock market associates higher interest rates with growth; growth brings higher earnings, and the market moves higher. However, the market balks when rapid increases in wages and prices of goods threaten the margins that public companies have enjoyed. Right now we’re not seeing inflation pressures but at a certain point, the market can turn against higher rates. We’re watching this carefully. There’s concern about the allocation between stocks, bonds, real estate, alternative investments and cash. When the first or second round of central bank tightening occurs we may be only mildly disappointed in bond performance and might see a net positive for stocks. We are looking to swap out of Real Estate Investment Trusts (REITs) into bank stocks when the Fed rate hike cycle starts. The sector will likely outperform once Wall Street accepts the reality of a sustainable economic recovery and interest rate hikes.

Election Primer – Does it Matter?

Money and PoliticsWith next month’s elections right around the corner people seem to be fed up with our legislators or feel that it just doesn’t matter who is running the country... Republicans or Democrats. The only thing we can bet on is that the Republicans will keep the House. The Senate seems to be up for grabs. It could be a huge win for the Republicans as the economy has been slow to recover. A slight GOP majority in the Senate won’t be able to overturn any vetoes, so we’re likely to see two more years of gridlock, with the possible exception of more oil exports and approval of the Keystone Pipeline. The White House would go along with these moves because they would help spur economic growth. Mounting debt will force our next president, (whichever party) to be more pro-growth. People like to see checks and balances in government – a Congress that can restrain a President, and vice versa. There are reasons to be optimistic.

Income for a Lifetime

The face of retirement in America has changed radically in recent decades. People are living longer. Thirty years ago, 89 of the 100 largest employers in the United States offered a traditional pension. By 2013, only seven did. Today, the responsibility for financing your retirement is likely to fall on your shoulders. With many similarities to a traditional pension plan, a fixed income annuity can provide a guaranteed stream of income that lasts a lifetime and is not vulnerable to the ups and downs of the market. By locking in some guaranteed income you will have the freedom to invest the remainder of your retirement assets for growth as part of a diversified income plan. A fixed lifetime income annuity represents a contract with an insurance company. Its purpose is to convert part of your retirement savings into a predictable lifetime income stream. In return for a lump sum investment, the insurance company guarantees to pay you (or you and your partner/spouse) a set rate of income for life. What makes fixed and immediate annuities interesting is they are not correlated to other investments; they mitigate three key retirement risks that can be challenging to manage on a short and long term basis. These include:

  • Market risk - Regardless of whether the market goes up or down, the insurance company is obligated to provide you with income payments every year.
  • Longevity risk - Rather than trying to figure out how much of your savings you can spend each year before running out of money, the insurance company assumes the responsibility for paying you as long as you live.
  • Inflation risk - By including an annual increase option, you can reduce the risk that inflation will diminish your investments' purchasing power over time.

Not all income annuities are alike—some might have high embedded fees or are issued by a company whose financial rating is low. There is a process to determine how much income you will need and what insurance company will be the right fit. There are numerous features to best meet your particular needs. We will take you through the process and determine if a fixed annuity is right for you.

Are You Prepared?

Natural DisastersNo matter where you live it’s important to prepare for natural and man-made disasters. The recent earthquake in Napa was a stark reminder of that. Whether it’s a disaster preparedness plan or an investment plan, the purpose is to spare yourself and loved ones some of the challenges that arise in the aftermath while also managing the on-going risk. In many emergency situations cell phone networks become overloaded and unreliable. Give a phone call tree to a family member or friend outside the immediate area. It may be easier to get a single call through to them and they can then pass your status on to others outside the area. Have a plan where your family should meet in the event of an emergency. Find out where the nearest shelter is located. Know your local evacuation routes. Review the plan with your family each year. In addition, develop an emergency contact list. Your list should include family doctors, utility companies, and insurance carriers. Keep a hard copy of the list in another location where it can be retrieved if your home is inaccessible. Make sure your family knows where to find the list in an emergency. Financially it is important to review your insurance policies to make sure you have the best coverage you can afford. Be sure that your homeowners insurance will cover the actual loss of your home and your personal property. If you are a renter, make sure you have adequate renter’s insurance. Your landlord’s insurance will not cover damage to your personal property. It is important to understand the exclusions and potential limitations of an insurance policy. Keep your most critical documents in a safe deposit box or other secure place where they can be retrieved when needed. Critical documents include your will, advance medical directive or living will and insurance policies. It may also be helpful to keep copies of these documents in an alternate location in the event the bank is inaccessible in the aftermath of a disaster. Having a basic understanding of what you need to do during an emergency will help avoid miscommunication and anxiety. You can learn more at www.ready.gov and www.sf72.org.

Managing Money

Barack's CubeNews and emotion will always drive the markets in the short term. Over time the market gyrations become muted and the economic, monetary and political fundamentals become the focal point for the markets. Clients often say it must be hard to predict the markets when the markets are so volatile. Our job is not about ‘calling’ the markets, but rather to ‘call’ the fundamentals behind the markets. If financial markets reflect what businesses are worth at any one time, then ‘calling’ the markets is the pursuit of someone who thinks and acts in the near term only. As an asset manager the goal is to position capital in line with the investment goals and risk tolerance of the client. Market valuations should be based on fundamentals — not a meeting of the Federal Reserve or whether an iPhone bends. The move we’re interested in should be measured over sector cycles, not over months and quarters. A few underlying factors drive the returns on money invested in the markets: the cost of capital and the ability to earn profits above that, and the discount rate used to determine the present value of future cash flows. None of us can figure out the next fluctuation in interest rates, the next gain in payroll jobs or the makeup of the next U.S. Congress. With some diligent research we can gauge whether we’re in the beginning, middle or end of a business cycle. We can also assess the economy’s competitive advantages and get a reasonable idea of the cost of capital and the direction of inflation pressures that businesses may face in that environment. In short, markets go up and down, correct then advance again, hit new record highs before falling back and so on. Those of us who are fundamentally driven investors have learned to coexist peacefully with daily noise, confident that strength and weakness will ultimately be gauged over the long run.

Supporting Effective Charities

Providing support to a charity is a meaningful way to express our values. As you prepare for charitable giving at year-end, consider providing general operating support so that an organization’s leadership has the flexibility required to respond to urgent needs and allocate resources where they are most needed. Among the 1.5 million nonprofits in the U.S, consider a tax deductible donation to ElderGivers– a nonprofit arts organization based in San Francisco. It offers older adults in the Bay Area the opportunity to explore and develop latent artistic talents. These elder artists – many of whom do not have families – make their homes in skilled nursing, assisted living, and board and care homes. With good management, and a strong and sought after program model, general operating support has a great impact on smaller organizations such as this one.

What We can Learn from a Chinese Billionaire

AlibabaAlibaba Group, the Chinese e-commerce giant, started trading last month after raising $21.8 billion in its initial public offering. Alibaba was the largest public company offering in U.S. history, yet very few people even knew what Alibaba was until recently. What is interesting is not that Alibaba is larger than Facebook in market cap or that it now trails only Google Inc., Apple Inc. and Microsoft Corp. in size among U.S. traded technology companies… it is the story of Jack Ma. Jack Ma now has an estimated net worth of $21.9 billion. He has brought China's private sector onto the world stage. He praises and uses western management techniques and decided to bring his company public not in China but in America through the New York Stock exchange. He truly embodies a successful entrepreneurial rags-to-riches story. It started in Seattle when a friend showed Ma the internet. He returned to China and set up a listing site that he later sold to the government. After working in Beijing for an Internet firm under the Ministry of Commerce, Ma returned home to Hangzhou to pursue his dream. With the help of more than a dozen friends who pooled their resources he founded Alibaba, a business-to-business online platform. The company has more profits than rivals Amazon.com and e-Bay combined, as China's burgeoning middle class are big spenders online, and small companies rely on Alibaba and its online payment system. Ma seized opportunities as China was transforming into a market economy. At the time, the Internet was first being promoted, and small, private businesses struggled to get loans and had to compete against government-protected state firms. He states “I got my story, my dream from America, a full 15 years ago when I came to America, and visited Silicon Valley. I saw in the evening the road was full of cars, all the buildings with the lights. That's the passion. The hero I had was Forrest Gump.” What is fascinating is Jack Ma has no background in computing and professes not to understand technology. Raised during China’s Cultural Revolution, Mr. Ma began his career as an English teacher. He is driven by doing whatever it takes for his customer….small businesses.

This is the key to any successful business and is the focal point of the partnership we have at Karp Capital with our clients. We celebrate the entrepreneurial spirit because it is this spirit that creates jobs, stimulates growth and improves the lives of people all over the world.

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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 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, 8th Floor
San Francisco, CA 94105

P: (415) 345-8185 F:(415) 869-2832
peter@karpcapital.com
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