The Third Quarter – Business Ethics 101

The third quarter of 2006 signaled a change not only in the seasons but in the Fed's policy, the markets and even politics. Numerous indices are now on the verge of hitting five year highs with some approaching unprecedented levels. 

The markets continued to rally as more questions are answered about the economy, the consumer and Federal Reserve interest rate policy. Wall Street doesn't like uncertainties and there are still two distinct schools of thought on the economy. Given the inverted yield curve, the bond market is telegraphing a recession. On the other hand, the stock market is supported by continued GDP growth in the midst of a real estate market that is clearly on the decline.

In this issue of Karp Capital Focus, we will address the reasons the market highs are different this time. We will also address the decline in the U.S. housing market and ponder the effect on our economy. In addition, we will discuss how the continuing wave of ethics violations impacts both the markets and the consumer.

Here are the performance numbers for the third quarter of 2006 and year to date as of 9-30-06 (absolute price return).

Everyone has been watching the Dow Jones Industrial Average (DJIA) as it approaches record territory, 11,722.98 set on Jan 14, 2000. However, it's important to remember that this level does little more than appease the investor's sense of well being. Only two Dow stocks are at record highs: Proctor and Gamble and American Express. The average Dow stock is down 34% from prior highs. Keep in mind the DJIA is comprised of 30 stocks and not representative of the market. The Standard and Poor's 500 is a broader market indicator and is still 14% below its all time high. Stocks rallied on a flurry of economic news to end the quarter with the Dow surging 4.7%, its strongest advance since the third quarter of 1995. The NASDAQ rose 4% in the quarter, its best third-quarter performance since 2003. The S & P also advanced 5.2% in the quarter (data provided by Bloomberg).

Is It Different this Time?

Soft landing for the economy...

On August 8 th the Fed paused in its campaign of rate increases for the first time in 18 meetings, leaving the Fed Funds rate at 5.2%. Officials decided the risk from the slowing economy outweighed concerns over inflation. This was a change from the previous Fed view on the economy. In the past, the Federal Reserve Open Market Committee focused on combating inflation with a great deal of concern over wage growth. At present, concern has shifted to the growth of the economy. Since the Fed met, stocks and long term bonds have rallied.

The housing market continues to deflate, yet the consumer is showing tremendous resilience by continuing to spend. Consumer confidence surged to the upside in September and rebounded from a nine month low. Existing home prices have fallen 5.9% annualized over the past 3 months according to High Frequency Economics. Last year, prices were up 16.4% year/year. Inventory for new homes is at a 6 month supply. The big question on everyone's mind is whether or not the housing slow down is going to prevent home owners from continuing to use their home equity for future spending. I believe the answer comes from the banking and lending community. The lending institutions have done an excellent job educating the consumer on how to use the current interest rate environment to their advantage. They have used the internet, phone and target mailing to get consumers out of high cost home equity loans into fixed rate loans which, in many cases, lower their payments. I believe this will dampen the real estate correction.

Also worth noting is the continued fall in the price of oil and gas. Gasoline inventories are surging. In the last week of September we saw the third largest increase in inventories in a decade. Gasoline prices are 15% below their three dollar plus highs reached in early July. On the business front, corporate profits came in strong again with another double digit growth for the twelfth straight quarter. In further analysis, seventy percent of companies reported earnings above expectations while eleven percent accurately met their projections (as reported by First Call.) If consumer spending can hold steady and business spending picks up, the economy can continue to grow at a sustainable but tempered rate.

Hard landing for the economy...

The inverted yield curve (difference between short, medium and long term rates, 3 month T Bill to 30 year treasury) has been an indicator of recession in the past. In addition, the economic data is conflicting. The Philadelphia Fed Reserve September business activity survey reported a negative reading for the first time in nearly three years. This signals slower manufacturing activity in the mid-Atlantic region.

Keep in mind the economic numbers on their own are not problematic for the economy. What's important is to identify future trends. The Consumer Price Index increased from 2% last September to 2.8% in August 2006. It was at the top end of the comfort range for the Fed. Lower energy prices and housing prices have put pressure on the CPI. The result is the consumer feeling pressure from deeper trends. As short term interest rates go up, the cost of food has skyrocketed. The Commodity Research Bureau reports that foodstuffs have jumped 14% over the past six months. Most growers and suppliers have to pay more to run their business; this cost is then passed on to the consumer.

Also, health insurance premiums rose 7.7% on average from spring 2005 to spring 2006 (according to the Kaiser Family Foundation). In the past six years, premiums have jumped 87% while worker's earnings have gone up 20% and general inflation has risen 18%. These are the costs that will make it difficult for the Fed to start lowering rates in the next interest cycle. Crucial pieces of the puzzle will begin to fall into place during the first week in October and it will be important for investors to factor in data gathered by the Institute for Supply Management Report (ISM). On Friday, October 6 th , the Jobs Report will be released. The Federal Reserve Chairman, Ben Bernache, is also speaking for the first time since the last Federal Reserve meeting. Together, these events will determine the course of the market for the rest of the year.

Going Back to School

In the past few years, I have witnessed the debacles of Enron, Tyco, World Com and the back dating of stock options. In light of the sentencing handed down to the poster children of corporate violations, Andy Fastow, ex -CFO of Enron and Bernie Ebbers, ex -CEO of World Com, I want to address the issue of ethics. Most of us hear about these gross violations through the media; it makes great news.... the rich and powerful of corporate America taken down to the level of mere mortals . Over the last five years there have been attempts to clean up Wall Street by Elliot Spitzer (New York's attorney general) and legislation instituted under the Sarbanes Oxley Act. Corporations like Citigroup have started online ethics training that is required for all its 300,000+ employees. Still, that does not seem to stop ethics infractions. The true effect is felt by the general working population. Pensions are lost, companies lose market value and role models for new businesses are formed. Given the never ending media coverage, we were witness to the recent resignation at Hewlett Packard of Ann Baskins, General Counsel, as well as Chairwoman Patricia Dunn stepping down. 

The topper came when Mark Hurd, one of the most respected CEOs of Silicon Valley, appeared in front of the Senate sub committee to comment on how private investigators hired by HP may have used illegal methods to obtain private phone records and other personal information to stop board room leaks to the media. Why does this continue? Could it be the punishment does not fit the crime? Could it be leaders of business and corporate executives don't have a conscience? Perhaps it's a little of both. People are over-scheduled and bombarded by constant stimuli through cell phones, emails and PDAs. Also, most violations are settled without admitting or denying guilt and are resolved by paying a fine. Mark Hurd was applauded for taking responsibility and showing remorse. This, however, is the exception and not the rule. The real solution is given to us early in life, in the basic principles of decency handed down to us by our parents. These principles are reinforced through the family and one can only hope that that they are still valued today. 

The Case for Stocks and Bonds—Our Investment Outlook

As we stated in our previous issue of Karp Capital Focus, we like the stock market with a focus on international equities. Given the rate pause by the Federal Reserve we are now constructive on bonds. After a rate pause, 2-10 year treasuries usually rally and bond prices go higher and yields fall. We have already seen the ten year yield drop to 4.65% at the end of September. We would start buying 5-10 year bonds depending on your investment horizon. It makes sense to lock up slightly lower yields for the additional eight years. This gives you not only current income, but it's an attractive total return investment if the economic downturn materializes. We would focus on high quality corporate bonds and treasuries.

The investment strategy for stocks is the following:

There is a flight to quality stocks as evidenced by the major market weighted indices approaching record highs. We are sticking with our defensive strategy for U.S. stocks. Our favorite sectors continue to be utilities, multi-national industrials and commodities. We would add to selective energy holdings as long as oil holds at the $60 per barrel level. In addition, we are adding international financials as one of our favorite sectors. If the consumer continues spending, this would further support our view of a weak dollar and a strong euro. We would continue to buy the Euro given the Fed pause and the large U.S. trading imbalance. We recommend growth investors having 25% of their portfolio in international stocks and bonds that have attractive valuations and better growth rates than U.S. stocks. 

Clients have often asked us about our position on gold. As the election approaches geo-political tensions will momentarily ease which will result in an artificial low in the price of gold. It's at this point we would strongly advise buying gold while it's at this temporary low as it will surely rise once the elections have come to pass. Investors can have exposure to our recommended sectors through mutual funds, closed-end funds and exchange traded funds. (ETFs)

The Opportunity

At the end of each quarter, portfolio managers add to their top performing sectors to show investors they have their portfolios positioned properly. This is called window dressing. Karp Capital Management wants to use this opportunity to rebalance portfolios and take profits. The Securities Industry Association and Wall Street analysts are overly cautious on corporate profits. This is understandable under the stringent regulatory environment. Now is the time to upgrade your portfolio to quality companies with predictable earning streams. At Karp Capital we are sitting with the lowest allocation of cash for our clients for the year. Stay invested.

Please remember that we appreciate your support and are 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. Furthermore, if you have any questions on the above analysis, 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

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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