The Tail Wagging the Dog

The first quarter of 2006 could be characterized by investor fixation on the Fed. When is the Fed going to stop tightening rates? Will the Fed tighten interest rates too much and push the economy into recession? How will the handoff between “The Greenspan Fed” to the new guard led by Ben Bernanke affect the markets and the economy? While investors and economists continue to focus on the Fed, we at Karp Capital would like to focus on where to position our clients’ portfolios for future growth and income with reduced market risks. In addition, we will discuss the concept that the United States does not move markets or set world economic policy as it did in the past. The world stage has become more interconnected and the United States has not adjusted to its new role. We call the concept “the tail wagging the dog”.

Here are the performance numbers for the first quarter of 2006. A few of the major indices reached multi year highs during the quarter. The Dow had its best first quarter since 2002. The NASDAQ marked its best first quarter since 2000 and the S&P 500 had its biggest first quarter gain since 1999.

The pundits have been predicting a housing slow down and now we are finally seeing the start of a correction. The inventory of unsold homes rose during the quarter to a nine year high, according to a U.S. Commerce Department Report. In February, new home sales dropped 10.5% to the lowest level since April 2003. Commodity prices continue to rise with one additional characteristic…extreme price volatility. The yield on the 10 year treasury note is starting to climb and the yield curve is showing a slight upward slope. In fact, these are the highest yields since June 2004.

Market Resilience

What is fascinating about this quarter is the resilience of the stock market. The Fed raised rates a quarter point on Tuesday, March 29th and the market sold off. The Fed suggested “further policy firming may be needed.” The next day the market roared back with the NASDAQ marking a 5 year high. This shows the strength of the fundamentals and momentum of this market. Corporate earnings growth should come in again at double digits. The S & P 500 posted fourth quarter earnings of 14% annual growth which was the 15th quarter in a row of double digit earnings growth. Even though we see strong earnings, the rate of growth is slowing. Industrial production beat estimates for the quarter and capacity utilization is at a 5 year high. Gross Domestic Product estimates have been on the rise, some economists are predicting 5% to 6%. Corporate coffers are full of cash. Stock buy backs continue, but some of the cash is finding its way into investments not in the traditional scope of business. For example, Bank of America, according to the Wall Street Journal, is in a joint venture to include a Ritz-Carlton as part of a complex that will include its headquarters. This is one of many examples of business taking on too much risk. As short term rates climb, liquidity will be squeezed out of the market. The consumer may be getting tired but business spending is starting to pick up the slack. Consumer confidence at the end of the quarter is at the highest mark since May 2002.

The tail wagging the dog – We believe that a client’s investment strategy needs to stem from world events and trends. Currently there are too many cross currents to determine a clear direction in the economy. The focus needs to shift towards world events and how those events impact various investment sectors. We like to look at how the U.S. fits in the global economy vs. how our policies affect the world. The markets are becoming more interconnected with The New York Stock Exchange going public after 213 years as a member only entity. Also, the NASDAQ made a bid to buy the London stock exchange. These events are a testament to the free market and benefit international commerce. The fear and protectionism that has been exhibited by congress is very troubling. If we continue on this path, employment can be effected. The blocked sale by legislators of U.S. ports to a Dubai based firm is already having effects on how the world views the investment climate in the United States. The United Arab Emirates may switch up to 10% of its $22.5 billion currency reserves from dollars into euros.

Senator Charles Schumer, Democrat of New York, and Senator Lindsey Graham, Republican of South Carolina, have introduced legislation that would impose a 27.5% tariff on all American imports from China in two years unless Beijing officials allow "substantial" appreciation in their country's currency. For the time being Senator Charles Schumer put a hold on the china vote. He came back from China and stated that the Chinese were taking steps to let the market determine the value of their currency. After this announcement the market had a short rally. Free markets benefit the consumer. Today the Chinese are willing to work unlimited hours and live frugally. This will change as economic wealth grows in China. A large part of our exports go to China. Given our ballooning deficit we can’t afford to disrupt free trade. Foreigners now own a record 13.9% of our debt market according to Ned Davis Research.

Oil producing nations continue to shape our oil policy. Venezuela is forcibly renationalizing 32 privately operated oil fields. Nigeria has been reporting pipeline sabotage in the Niger Delta region. Facilities operated by foreign oil companies have been the target. In addition the U.S. has been at odds with Iran’s nuclear policy. Iran is the 4th largest producer of oil in the world. Japan and China are Iran’s two biggest customers. These events are adding a premium to oil prices. This is not just a supply driven problem it’s also a demand issue. China, India and the emerging markets are demanding oil, to meet the global demand of products and services.

The Fed and Interest Rates – What have we seen from Ben Bernanke and the Fed so far? He wants to keep the continuity of Fed policy. On March 28th the Fed, FOMC, raised rates for the 15th consecutive time, bringing the Fed Funds rate to 4.75%. Given the Feds hawkish view of inflation we believe at least two rate hikes are in the cards. There is a lack of evidence that growth has moderated. The unemployment rate dropped from 4.9% in December to 4.7% in January, this was below estimates. Also, hourly productivity of workers has shown a recent decline. The Fed comments were clear and concise, wage pressures are still persistent. Bernanke will not be moved by politicians who think fed policy is being too restrictive. Politicians want to play to their constituents given the upcoming mid-term elections. In fact, Bernanke will probably have to push rates higher than he would have, given the building inflationary pressures on the markets. The pictures we saw from the Fed meeting and the format of the comments illustrate the transparency Bernanke is trying to create at the Fed. This should be settling to the markets. Keep in mind that Bernanke is in a good position. He has taken the reins when the economy is strong and inflation has been kept in check. He does not want Fed policy to rock the boat.

International – The Japanese markets continue to recover. Year over year exports are up 20.8%, the highest in 9 years. The Nikkei 225 Index hit another multi-year high during the quarter. The jobless rate in Japan fell more than expected and workers’ household spending increased to 3.2% year over year. The data has helped to push the Bank of Japan in preparing to change its zero interest rate policy. They have pledged to remove excess liquidity out of the market. This opens the door for rising interest rates. In addition, the European Central Bank has raised its key rate twice in the last three meetings. This could influence the appetite foreign central banks have for our treasuries. We want to overweight our international investments in India and South America. As we have stated in past newsletters we like South America, staying consistent with our focus on commodity companies. In addition, we continue to favor the emerging markets where there is a higher return on capital given inexpensive labor and technology.

Investment Strategy – The bond market has been focusing on inflation while the stock market is focused on growth. Bonds are still not attractive at these yields. We would start buying high quality bonds if the yield on the 10 year treasury bond climbs over 5%. We buy CDs and preferred stock for investors who are looking for income. On the equity side the question is how much we will have to pay for companies with superior earnings growth. This brings up the issue of trying to grow your portfolio quickly. As I have mentioned before, investors are taking on too much risk for the return they are receiving. More than ever, investors are increasingly focused on the potential gain, rather than the probability of actually earning that return. In our last newsletter we explained why gold was added to our portfolio. On price dips we continue to add gold. We feel the dollar will weaken and foreign economies are awash with cash to buy the commodity. As rates continue to climb, our sector focus includes the following: Healthcare, Energy, Utilities and Commodities. Stock prices are not appreciating as fast as earnings. The price/ earnings ratios are still depressed. Russell Investments states that over the last 4 years earnings are up 140% for the S&P but the prices are up 16%. We feel that this is a temporary situation and plays into our forecast for higher stock prices. In the meantime, given the trading range of the market and the volatility we have been trading around our core positions. This helps use reduce risk in the portfolios while boosting returns. Also to mitigate volatility we blend different asset classes and are starting to add more fixed income to the portfolios. The problem with more diversification is that returns tend to be diluted. When the Fed stops tightening we would focus on technology and the consumer discretionary sector. Looking forward, we see strong first quarter corporate earnings to power stocks higher.

Action Plan – As I stated in our last 4 quarterly newsletters, I have been a proponent of reviewing your current real estate loan program. The rates have moved higher for most of the fixed rate loans. The loan rates are now anywhere from 1/4 to 3/8 percent higher than 1 month ago. If you have an equity line, now is the time to convert it to a fixed rate loan. Do not procrastinate any longer. Our view is the Fed will continue to raise rates. We have a mortgage analysis that will help determine if you are in the right loan given the rising rate environment. In addition, if you are nearing retirement now is the perfect time to lock in these high real estate prices. I have a strategy to help you supplement your retirement. Everyone should have a mortgage that fits their needs and investment goals.

NOW is the time to fund your IRA. Contributions can be made to your IRA for the tax year 2005 by the due date for filing your 2005 tax return, not including extensions. For most people this means contributions for 2005 must be made by April 17, 2006. This includes traditional and Roth IRAs. Traditional and Roth IRA contribution limits are $4,000 for both tax years 2005 and 2006. “Catch up”(Age 50+) contributions are $500 for tax year 2005 and $1,000 for tax year 2006.

Business owners should review their corporate retirement plan. Would you like to further reduce your taxes and save more money for retirement? Of course! Did you put away the $42,000 and “catch up” (Age 50+) of $4000 into the retirement plan in 2005? We will help you review your plan to not only make sure your plan is in compliance but also to make sure you and your employees have the right plan design. When was the last time your plan was reviewed?

Have you ever felt...

• I spend too much time managing my money and not doing the things I truly enjoy.
• I am close to retirement and need help getting my personal finances in order.
• I am turned off by the never-ending hype of products and services by Wall Street.

If you answered yes to any of these questions it is time to create and implement a clear, concise investment plan. Make a conscious decision to manage your finances on your terms.

Please remember 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 working with us, please call me at 877-900-Karp. Working with Karp Capital, there is only one boss… you.

Peter Karp

Karp Capital Management
Registered Investment Advisor
2269 Chestnut St. #308
San Francisco , CA 94123
(P) (415) 345-8185; (F) (415) 869-2832

peter@karpcapital.com

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