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The Eye of the Storm The Third Quarter was trying for the financial markets and the country in general. Our hearts go out to the people of the Gulf Coast and the people involved in the relief effort. The markets started the quarter very strong with good economic news. We got stronger than expected retail sales, consumer sentiment numbers, and industrial production numbers. In addition, investors were happy to see flat consumer and wholesale inflation data. The stock markets celebrated with the S&P 500 hitting a Four Year High; not what you would expect from a summer market. Investment professionals call it the summer doldrums. Then events started to affect the market. The Fed continued to raise rates, oil prices accelerated, we had two devastating hurricanes and consumer confidence crumbled. Talk about an event packed quarter. Here are the performance numbers for the quarter and year to date through September 30 th (in absolute returns).
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Now for the Analysis THE CONCERN OF THE FED - The Fed has boosted short term rates from 1% in June 2004 to 3.75% in September 2005. The fed has never before raised rates in 11 straight meetings. This has been the focus of investors. The real focus should be that credit was very cheap. September 11th caused the Fed to cut rates 13 times from 2001 through 2003; this was unprecedented. The fact of the matter is inflation has been on a slight upward tilt the past couple of years. Currently the inflation rate is near the upper end of the Fed's tolerance zone, and it shows little inclination to go in the other direction. The goal of the Fed is to achieve a "neutral" interest rate that would neither boost growth nor restrain it. We now face higher energy prices and businesses' desire to pass the increased costs on to their customers. Combine the energy spikes with spending increases by governments at every level in the aftermath of the two hurricanes and you have new demand pressures added to the old ones. The Fed also knows as they raise rates it affects consumer spending. Consumer spending makes up 70% of the economy. Although both Hurricanes Katrina and Rita have wounded the U.S. economy, the Fed does not seem worried about any long-term negative impacts on economic growth. After all, the economy was humming along pre-Katrina. With approximately 160,000 homes and 400,000 vehicles destroyed from flooding, these households and vehicles must be replaced, which will help boost U.S. economic growth. Additionally, all the federal spending to repair damaged infrastructure (bridges, highways, levees, etc.) will likely stimulate U.S. economic growth well into 2006. The Fed will continue to raise interest rates through the end of the year. I don't think the yield curve will invert (the difference between short-term and long-term interest rates is negative). In fact, at the end of September the curve was getting steeper. The next Fed meeting is November 1. WHERE IS THE MONEY GOING? - "The final tab is likely to be less than $150 billion, instead of an estimated $200 billion or more that was tossed about immediately after Hurricane Katrina hit the Gulf Coast in August", said Congressional Budget Office Director Douglas Holtz-Eakin. Even at $150 billion this is a huge cost. In addition the cost of the war in Iraq is rising. It's about $1 billion more a month than last year, according to another congressional report. The Congressional Research Service said in a separate report that the Bush administration is spending about $5.9 billion a month on the war, a 19 percent increase from a year ago. In addition, Congress passed a massive $286.4 billion highway bill. If you add all the hurricane reconstruction to this highway bill, the number of construction projects that will be under way in the U.S. will be at record highs. At the current 4.9% unemployment rate, wage inflation will become a problem. The accumulating costs of both hurricane relief and the war have prompted House GOP leaders to unveil a new bid to squeeze the federal budget to pay the bill. Their plan would cut another $15 billion from federal benefit programs such as Medicaid, food stamps and farm subsidies already slated for $35 billion in spending cuts. This is just the start. Additional monies need to come from somewhere. That somewhere is from the American Taxpayer and/or more Treasury Debt. This additional supply of bonds would probably raise bond yields and depress prices. The Federal government is backing the Federal Open Market Committee against the wall. The Fed is the "tail wagging the dog". INVESTMENT STRATEGY - In order to determine how to achieve our goals we must organize the available market information into a manageable process. Above all we must have a goal when it comes to our investment strategy. Please keep in mind that the event driven declines in stock prices are usually short lived. These are times that create opportunities...this is on the buy-side and the sell-side. The Value Strategies that have worked over the last few years will start to under perform. The shift to growth has become more apparent as evidence mounts that earnings for the recent quarter and perhaps the year could disappoint. Investors need to gravitate to shares of companies that promise robust earnings, supporting the Wall Street adage that "when growth is scarce, the market tends to value it like diamonds." The large cap growth stocks are extremely undervalued. As of 9/26/05 , Ned Davis Research "Russell 100 Growth Index vs. NDR Fed Valuation Model" indicates that the Russell 100 Index is 40% undervalued. In addition, the Russell 1000 Growth Price/earnings Ratio, Price/ sales Ratio and Price/ Book Value Ratio are all below their 24 month averages. INVESTMENT FOCUS - Bond Market - The market is not paying us to take on risk. The yield curve is fairly flat, and so we will continue to invest in short term bonds. We currently like municipal bonds and some high-yield issues. If taxes go up we would be more bullish on MUNIs. Stock Market Focus - U.S refineries are spending record profits to improve efficiency instead of expanding production. The bottom line is there are not enough refineries to keep up with demand and the numerous gasoline mixes required by federal and local governments. We continue to buy and hold specific oil service and refinery stocks. In addition, we like utility and natural gas stocks. For the near term we are adding to our position as we go into the fall season. We also like selected consumer staple and specialty retail stocks on pull backs in the market. When the market drops you have rare opportunities to pick up quality companies with superior growth. We continue to under weight the financial sector as the Fed continues to raise rates. Many banks have eased their lending standards and competition has forced many banks to take on increased risk. We have increased our allocation of International Stocks and Bonds. There are plenty of countries that have improving business climates and are fiscally responsible. CONCLUSION - WHAT'S NEXT - The surprisingly strong Job Reports give the Federal Open Market Committee a green light to keep raising interest rates. I believe the sharp drop in consumer and business confidence will be short lived. The recent volatility of the market reflects the cross currents of rising energy cost, inflation fears, and the rate of change in the major business surveys. The noise surrounding the fundamentals of the stock market will die down. The fundamentals are intact and the market will trend higher. Can the market rally if the Fed continues to hike rates? Yes. Valuations are low. In addition, oil prices appear to have made a near term top, corporate balance sheets are strong and earnings have been growing. The key is to be invested in quality companies with superior earnings growth. In addition, adhering to a strict allocation of stocks (U.S and International), bonds and cash will lower the swings of the market. Stay tuned. SOME ACTION ITEMS FOR CLIENTS - If you are a business owner please call us to review your current retirement plan going into year end. There could be plan designs that can help you reduce your taxes and save for retirement. In addition there is a new Roth 401k. Please call for more information. Individual investors should consider tax reduction strategies and year end tax planning. Please call us to establish or review your financial plan. Given the current Federal Reserve interest rate hikes, please call me to review your current real estate loan. Karp Capital's position is short term rates WILL go higher and now is the time to lock in these historically low rates. If you have an equity line or an adjustable rate loan (one month, 6 month or LIBOR) do not wait. When the Fed raises rates, your payment will go up. I will custom design a mortgage for your financial needs. Please keep in mind we appreciate your support at Karp Capital and we are flattered when you refer your family and friends. If you have any questions on the analysis above or know someone that would benefit from a clear and concise investment plan, please call me at 415-345-8185 or 877-900-KARP. I look forward to hearing from you.
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