Karp Capital Management Focus

4th Quarter Report

Written by Peter Karp
January, 2015

Glass Half Full

Vaccines for 2015

The fourth quarter of 2014 was marked by several bouts of intense market volatility in the bond, equity and currency markets. As expected, the Federal Reserve announced the end of its bond buying program and stated once again that interest rates would remain low. The Fed also upgraded its assessment of the labor market. Uncertainty over economic slowdowns in Europe and China, falling oil prices, ambiguity regarding the Fed’s monetary policy and fears of Ebola gripped the headlines in 2014. But the news flow regarding the U.S. economy remains relatively bullish. GDP strengthened over the last two quarters and economists are predicting a revision on the upside. Looking at the recent signs of strength in consumer demand and other economic indicators, we should continue to see strong non-farm payroll reports. The Fed’s timetable for rate hikes should soon be clear; short term interest rates at a zero level are not sustainable. In June, Fed Chairperson, Janet Yellen, will likely push for an initial rate hike. Deflation and world economic woes need to be balanced with the remarkable strength of the U.S. economy. With the notion that the U.S. economy is the miracle child in the global economy we will lay out our investment strategy in this installment of Karp Capital Financial Focus.

In This Issue:

Glass Half Full

Market Performance

Where is the Market Headed in 2015?

The Power of the Central Banks

Why is the Price of Oil Falling?

Russia – At a Crossroad

Good to be King

A Bond Primer – Sell High / Buy Munis

Looking for Opportunities

Consensus Will be Wrong

Psychology Drives the Markets

Signs of Progress

Can You Afford Big Mistakes?

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Market Performance

Here are the performance numbers for the major indices as of 12/31/2014:

Latest
1 Month

Latest
3 Months
2013
% Change
2014
% Change
The
Close
Dow Jones Industrials
0.11%
5.19%
29.65%
10.02%
17,823.07
Standard & Poor’s 500
-0.25%
4.93%
32.39%
13.69%
2,058.90
NASDAQ Composite
-1.08%
5.75%
40.16%
14.82%
4,736.05
Russell 2000
2.85%
9.73%
38.82%
4.89%
1,204.70
MSCI EAFE
-3.44%
-3.53%
27.46%
-4.48%
1,774.89
Long Term Treasury Bonds
3.05%
9.07%
-13.29%
26.34%
Gold
1.40%
-1.42%
-27.79%
-0.19%
$1,199.68
The big surprise in 2014 was long term Treasury bonds. They outperformed stocks with a 26.3% total return. Utilities (+24.3%) was the best performing sector in 2014. Healthcare posted a 23.3% gain,outperforming the S&P 500 for the fourth consecutive year. Tech (+18.2%) contributed a third of the S&P 500's 2014 gain. Among the five biggest contributors last year, three were old tech (AAPL, MSFT and INTC). Energy was the worst performing sector (-10%) as crude prices tumbled 46% in 2014. The small cap index lagged large caps by the widest margin since 1998 (Russell 2000 +4.9% vs. Russell 1000 +13.2%) Across all capitalization ranges, defensive strategies such as low volatility and dividend yield outperformed.
Sources : Thomson Reuters; WSJ Market Data Group, Dow Jones & Co., BTN Research, BofA ML, U.S. Global Investors.
Stock market indices do not include reinvested dividends.



Where is the Market Headed in 2015?

Bull Market HysteriaThe markets are lining up to look quite different this year compared to 2014. The first quarter of last year started off rocky. Estimates by the federal government put GDP growth at an anemic annual rate of -0.1% to -2.1%. It was the weakest quarter for the U.S. economy in five years. The average annual growth rate of 4.8% in the second and third quarters of last year certainly justified our optimism for the U.S. markets. We see continued market strength in spite of, and because of the deep chasm between the U.S. economy and those of many developed-world economies. Economic resilience at home does not mean U.S. assets are immune to the global slowdown. During much of December the S&P 500 Index traded down, with energy and technology leading the way on concerns over global growth. The biggest losses were once again in the commodity sector. U.S. benchmark WTI crude slipped below $60/barrel. With risky assets selling-off, investors fled to safe havens such as German bunds and U.S. Treasuries. In 2015 we believe we will see this scenario continue as markets adjust to lower commodity prices and the global economy stabilizes. We expect another good year for U.S. equities thanks to a resilient U.S. economy. Earnings will improve in a few sectors based on a pickup in consumer spending, low commodity prices and still-low interest rates. Europe remains troubled by deflation issues bordering on recession. The volatility in energy prices could trigger credit issues and negatively affect the global financial system and U.S. corporate bonds. This might put interest rate hikes on hold. We expect 2015 to be a year in which investors would do well to stay over-weighted in equities and long term quality bonds. Based on GDP forecasts, the U.S. is headed into a fundamentally bullish environment. The benefit from the collapse in oil is referred to as the Robin Hood Effect. Falling prices on rent, food, utilities and gas benefit lower and middle class consumers. It is redistributing income to the average Joe from the Saudi princes, oil billionaires and Vladimir Putin. Given our view of the economy and capitalizing on lower oil prices, we are focused on the following sectors and investment styles: consumer discretionary, utilities, small cap companies, and long term bonds.

The Power of the Central Banks

Paths for the FedThe U.S. was the leading source of strength in the world economy in 2014. The Federal Reserve by way of its measured monetary policy in winding down its bond-buying program is taking the credit for that strength. Investors feared that the Fed’s decision to taper and subsequently end QE3 would trigger a selloff in stocks or cause the economy to stumble. Instead, markets have advanced and the economy continues to grow. However, it carries implications for the likely path of Fed monetary policy and market interest rates. Fed Chairperson Janet Yellen was like Santa Claus, sprinkling good tidings on financial markets. Other central bankers were also busy during the last quarter of 2014, either defending (Russia) or attacking (Switzerland) their respective currencies. Russia's central bank dramatically raised its key interest rate to 17%, from 10.5%, in an obvious and desperate attempt to stem the dramatic slide of the Russian ruble. Russia's central bank chair did little to calm the currency or financial markets, so many traders are closely watching Russian bonds for a potential default or, more likely, the inevitable devaluation of the ruble. There is obviously a lot of capital flight around the world seeking higher interest rates. We should see a large amount of European capital find its way to our shores, further strengthening the U.S. dollar. Looking forward, 2015 will go into the history books as the year that the U.S. economy and financial system finally emerged from the shadow of the 2008-2009 recession and financial crisis. The Fed has been extremely patient and accommodative since the financial house collapsed seven years ago. Some people are having trouble accepting the idea that the U.S. economy is ready for the Fed to take the next step in normalizing monetary policy. But, as oil prices accelerate to the downside, the markets tend to over-correct at warp speed. This over-correction makes it almost impossible to model. The market can barely catch its breath.

Why is the Price of Oil Falling?

Putin's FlameAt the end of November, the Organization of Petroleum Exporting Countries (OPEC) announced it would maintain current levels of oil production, indicating low prices would continue. Saudi Arabia and the other OPEC nations are starting to acknowledge that the U.S. is now a formidable force in the global oil markets. As improvements in productivity, technology, and processing continue to evolve, so does U.S. oil production. Various theories have been bandied about as to why the Saudis continue to allow oil prices to fall. One theory is the U.S. and Saudi Arabia are conspiring to derail Russia’s economy with lower oil prices since oil exports account for over 75% of Russia’s economy. Some Saudi officials see Russia and Iran as adversaries when it comes to Syria. Another camp believes that OPEC is trying to force U.S. shale oil producers out of business by driving down oil prices and shrinking their profitability. The global economy benefiting from lower oil prices is merely a byproduct of OPEC’s decision, not an OPEC goal to help global growth. If anything, it suggests the weaknesses of policing behavior in a cartel economic structure.

This fall in oil prices is not without its risks. Nearly 30% of capital expenditures in the S&P 500 were made from energy related stocks in the past year. Much of this spending will be gone in 2015. The U.S. is not alone in facing problems with lower oil costs. One of the reasons Europe is facing a possible recession is the decline in oil prices. Falling commodity prices acerbate the already troubling deflationary pressures in the Eurozone. Also, Russians are key trading partners with Europe so a Russian recession could have detrimental effects. We see the reduction in oil prices as a net positive, as most companies use oil and clearly most consumers do as well. During the last major decline in oil prices the stock market climbed dramatically.

Russia – At a Crossroad

Ruble Before and AfterThere are two possible scenarios stemming from lower oil prices that have decimated the ruble and hurt the Russian economy. Putin may become more amenable to the wishes of the West and pull out of Ukraine, which will temper anxiety around the world. Or, Putin may find (at least temporarily) more support for his aggressive nationalistic policies by convincing Russians that they must not give in to purported U.S. and Saudi manipulation of the oil market. Russia's central government expenditures are based on revenues of $100 a barrel, not the $50-$60 range we’ve seen recently. It's only a small simplification to say that Russia doesn't so much have an economy as much as it has an energy-exporting business that subsidizes everything else. That's why the combination of more supply from the United States, and less demand from Europe, China, and Japan has hit it particularly hard. For the ruble to stabilize, oil is going to have to recover, and who knows when that will happen. Not many are shedding a tear for Vladimir Putin, but there will be economic fallout across the globe. Emerging markets such as Mexico and Brazil have been getting hammered, and it's starting to feel like 1998 all over again. Back then, oil prices were plunging, currencies were spiraling and Venezuela was caught in a financial tailspin while Russia was sinking into debt default and devaluation.

Good to be the King

Falling CurrenciesThe U.S. dollar closed at a high water mark in 2014 and is now sitting near an 8-year high. Recent remarks by the Fed on interest rate hikes in 2015 and the spectacular decline in many commodity prices in the second half of last year have fueled the rise of the dollar vs other currencies of the developed world. We have to remember that a strong dollar is good for some, bad for others. A strong dollar versus the yen is good for U.S. consumers buying goods and services from Japan, but bad for U.S. exporters trying to sell goods and services to Japan. This is why we continue to monitor Europe, Japan, and China carefully. In China's case we expect to see interest rate cuts in the coming months and the easing of stringent bank reserve requirements. An artificially strong dollar could accelerate deflation abroad and is the fear of every central banker. This means the Fed's 0% interest rate policy could last through mid-year at least. The Fed’s balancing act over the timing of a rate hike is central to continuing the domestic economic recovery and is a consideration when fine tuning our investment focus for clients’ portfolios.

A Bond Primer – Sell High Yield / Buy Munis

We refer to it as the bond market, but it's actually several markets, and currently some of them are wildly inflated. Normally the junk bond market yields 8%-12%. Currently the average yield on junk bonds (high yield, non-investment grade companies) is about 5%, reflecting the fact that junk bond prices have run up significantly as investors have searched for higher yields. The default rate on these bonds has been about 30% historically. If the bonds default, investors lose their principal with little recourse. On the other end of the risk spectrum, municipal bonds are issued by state and local governments to pay for roads, infrastructure, and other capital projects. In 2014 we bought municipal bonds. Municipal bonds performed well during 2014 and outpaced taxable bonds. Notwithstanding some isolated credit issues, we think this asset class will continue to do well. We continue to be amazed that some investors will assume risk in sectors like emerging-market debt, while overlooking U.S. municipal bonds. They are exempt from federal and state tax (if you live in the state of the issued bond). If you are in the mid to high marginal federal tax bracket and live in California your income tax rate could approach 50% (federal, state and 3.8% net investment income tax <Obamacare tax>). When we blend highly rated municipal bonds and U.S. Treasuries in our clients’ portfolios we can take larger equity risk positions without increasing overall portfolio volatility.

Looking for Opportunities

The inability to get credit has been a headwind in the housing market in the past few years, but with the potential easing of down payment rules, and an improving subprime mortgage market we may see expansion. More lending sources (credit unions, smaller regional banks) are joining the market looking for returns. Certainly we aren’t hoping for a return to the days when mythical characters like Santa Claus took out mortgages with no paperwork. It’s a win-win when younger and less wealthy citizens have an easier time obtaining home financing. With lower interest rates and institutions willing to lend, real estate investment opportunities are created. The U.S. real estate investment index was one of the best performing asset classes in 2014.We are looking to expand our real estate exposure given this trend. In the 4th quarter of last year we began adding U.S. building suppliers to our portfolios while holding on to our REITs (real estate investment trusts). Falling oil prices will serve as an enormous tax break and will put more money in the consumer’s pocket, making home ownership a reality for more people. Additionally, if you haven’t refinanced your mortgage in the last six months, there is the possibility of large savings as a homeowner. Significant drops in mortgage rates can keep more money in your wallet. Call us today so we can run the numbers and determine if refinancing is right for you.

Consensus Will be Wrong

Investing in large cap index funds on dips in 2014 was a strategy that worked. It’s the equivalent of putting your money to work in every sector and company of the S&P 500 Index…but is it? In 2014 it was impossible to manage total portfolio risk and volatility and come close to S&P 500 returns in the equity portion of a portfolio. The construction of the largest indices is skewed to the largest companies held in the index. Owning a market cap weighted index with a minority of stocks determining the majority of returns is not a sustainable strategy. Seeing the returns of the largest indices without understanding the construction of the index can lead to overconfidence by investors. Passive investing is a viable long term strategy if the indices making up the portfolio are rebalanced at specific intervals. Investing in specific sectors is based on economic fundamentals and controls risk. Most individual investors don’t have the ability to deconstruct the indices and understand how to hedge their portfolios during recessions or market declines. This means average investors have only a few choices when it comes to risk management. Too often, it means taking the risk and eating the financial losses when the cash is most needed. Retirees living off the accumulation of liquid portfolio assets need to take heed. Pre-retirees are facing financial risk because they began saving later in life and have a longer life expectancy. If you have questions about how we construct your portfolio and lower volatility to help you reach your portfolio performance goals please give us a call.

Psychology Drives the Markets

GDP GrowthMarket psychology, more than fundamentals, moved the market in 2014. Worrying about the Federal Reserve raising interest rates, slowing growth in Europe and a potential global health crisis stemming from Ebola had investors taking profits after an impressive run in the market. In December we witnessed corrections of 7%-12% across various broad market indices. The size of this correction was not unexpected, but the short timeframe was unusual. 2015 started off with five days of selling and a 680 point drop in the Dow. In early December of last year we saw the Dow fall 890 points during a seven day trading period. Keep in mind positive news may come from better than expected Q4 (2014) corporate earnings. Those numbers will come out over the next several weeks. A year ago the market started out with a drop of 4%, and then managed a 16% gain over the following 11 months. Long periods of consolidation or internal rotation can rid the market of its excesses from the previous bull market and set it up for new highs. That may well be the case for 2014, a year of consolidation where excessive investor optimism cooled. We kept the Dramamine handy. Thankfully we raised some cash beforehand, unfortunately we didn’t raise enough cash (in a downturn, you never do) and the prices of many of our holdings fell with the marketplace. Although economic numbers change gradually, the markets’ response to the data and world events can be rapid. We will continue to keep the Dramamine handy.

Signs of Progress

In the past 30 years, the Consumer Price Index (CPI) is up 126%, while oil is up 116%. This is a result of a shift in the oil supply curve due in part to new technologies in energy such as horizontal drilling and hydraulic fracturing. Two things are happening to keep a lid on demand; developing economies like China and Russia are experiencing slower growth. Second, new technologies – like LED lighting, more efficient computer chips and less waste in office buildings, homes and manufacturing – are reducing energy consumption. An iPad uses $1.36 of electricity every year, while a desktop computer uses $30 worth of electricity per year. A shift in the supply curve is occurring at the same time demand is falling. The drop in oil prices is a good sign, not one that indicates economic problems. Overall falling oil and commodity prices are a net positive for the global economy. Markets will continue to be volatile (more Dramamine) as consumers and businesses around the world adjust to lower oil prices.

Can You Afford Big Mistakes?

Investment setbacks more often come not from errors in analysis but from those that are psychological in nature. People always ask what we think of their investment strategies. Most want to discuss alternative investments including initial public offerings, options, hedge funds and private placements among other non-liquid offerings. Often these types of investment opportunities are presented in such a way as to appeal to vanity by way of exclusivity. It’s not to say that these investments aren’t viable, but there might be more suitable paths to maintain and grow wealth with less risk and greater liquidity. For most people this is solved with a simple core portfolio constructed with individual stocks, bonds and exchange traded funds (ETFs). We believe the fees you pay should be for prudent investment advice and guidance and not on the investment products themselves. We believe a core indexed portfolio should focus on specific investment sectors determined by where we are in the economic cycle. Combining asset management and tax reduction strategies with an adequate savings plan can get you to your financial goals. Straying too far from core investment strategies is what gets people into trouble. We’ve seen that during the heat of a market decline, people lose the ability to reason. For some investors, performance is about outperforming the S&P 500. Beating the market is not necessarily the appropriate goal for every investor. Obviously it would be great to beat the market every year but essentially this goal is impossible if you want to adjust for risk. We start with 60/30/10 core portfolio designed to capture the upside of the stock market while mitigating some of the downside in a market correction. If the strategy is successful it would lag the broader U.S. stock market but also spare investors a lot of pain. Its objective is to smooth out the ride as you move toward your financial goals. What worked in 2014 will not work in 2015.

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As our newsletter demonstrates, we recognize and appreciate the work of political cartoonists and satirists. Although we don't always agree with the views expressed, we support their efforts to put our world into perspective. We are deeply saddened by the tragic loss of life in Paris recently and wish to extend our sympathies to those affected and the families of those extinguished on 1/7/2014.

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 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: 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 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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