The first quarter of 2007 has been anything but predictable for investors. Some might say it’s been a rollercoaster ride.    Given the uncertainty of the economy’s strength, Wall Street began the year by focusing on corporate earnings. Commodities, ranging from copper to crude oil, started to sell off. This was a sign that the economic slowdown was already under way. However, as the quarter continued, it was evident that the consumer and the economy were stronger than first anticipated.       The U.S. trade deficit fell for a third straight month as exports of commercial airplanes and other products hit an all-time high. In addition, national expenditures on foreign oil declined. Unemployment continued to hold steady at 4.5% and remained just above the 5 ½ year low of 4.4%. The Dow Jones Industrial Average (DJIA) climbed throughout the quarter culminating in a record high of 12,700 on February 14th. The NASDAQ hit a 6 year high and the S&P 500 hit a 5 year high.   Presently, growth stocks are trading at the lowest valuation in over a decade. What a time to be a BULL ! ! !  Then the music stopped.  Cracks were starting to appear in the underpinnings of the major averages. HSBC Holdings, the third largest bank in the world, announced in February that it expected bad debt charges to exceed forecasts by 20%. Those charges stemmed from home-owners unable to pay their mortgages. The Mortgage Bankers Association reported non-prime loans accounted for 20% of new mortgages last year and 13% of total home loans outstanding.   Then the cracks in the housing market were confirmed. Housing starts fell 14.3% in January, the lowest level in nearly 10 years. This culminated with Alan Greenspan, (ex-Federal Reserve Chairman) saying that a recession in 2007 was “probable”. His speculation ignited a worldwide market sell off with investors selling off their stocks beginning with the Asian markets. On the first day it took the Chinese market down 9%, the Nikkei Average in Japan dropped 4% and U.S. markets sank 4%. The selling and market volatility continued until the middle of March when the U.S. markets staged a massive about-face. The turn around was helped by the Federal Open Markets Committee meeting whereby fed officials softened the interest rate tightening stance.   Why is all of this information so important? The answer is simple; if you don’t understand the mechanisms that influence the market, it’s difficult to lay out worthwhile investment strategies.    In this installment of The Karp Capital Focus we will shed light on why the events of the first quarter are key to understanding where the economy is headed in 2007. Also, we build a case for our investment strategy and why we think an index portfolio is appropriate in this market environment.     What the Sub Prime Mortgage Market Really Means   In the wake of problematic loans made to riskier borrowers at the height of the housing boom, the era of easy mortgage money has disappeared. Lenders now require more financial documents, larger down payments and proof of greater credit responsibility from potential borrowers. Still, the tougher underwriting standards won't prevent most mortgage applicants from getting a loan. These standards aren't likely to remain in place for long, especially if the housing market regains its footing later this year.  However, they are limiting options even for the most creditworthy borrowers and forcing first-time home buyers and those with less than stellar credit to go back to the drawing board and rethink their purchase or refinancing options. Lenders are also shying away from loans that cover 100% of a property's value and scrutinizing cash-out refinancing requests. The impact on all borrowers is not insignificant.   The small business owner is one group of borrowers that will find the going more difficult. Generally, as a group they make up those who choose no- or stated-income loans. These borrowers, who find it hard to document their income because it is earned irregularly, may need to make some concessions. Also, some borrowers will be shut out of the market all together. Borrowers who have low credit scores but good income could pay a higher interest rate given the perceived lending risk. With many housing markets throughout the country cooling significantly, more homeowners aren't able to tap home equity and instead are missing payments, defaulting on their loans and heading for foreclosure -- often after the interest rate on an adjustable-rate loan resets.  That has caught the attention of lenders, even if they aren't hit by the sub prime fallout, making them more conservative as a result. Moody’s reports that 40% of all loan originations last year and a quarter of all debt outstanding is sub prime including other aggressive loans.  A serious issue facing residential home builders is the oversupply of homes on the market after the speculative bubble. More home buyers are walking away from contracts, pushing builders' cancellation rates well above historical norms.   The sub prime woes are not going to bring down the rest of the economy. I believe recession is not on the horizon, but I do think there are serious concerns in the economy’s future.  These are the same problem areas I’ve mentioned in prior newsletters. Credit is not going to dry up but there will be structural changes in some sectors of the credit market.  Yes, this crisis comes at a time when corporate profits are slowing and economic growth is wavering. The bottom line, in my opinion, is that the perceived turmoil the financial markets have experienced recently is not atypical of a late-cycle expansion.  Markets in the United States, Asia, Europe, and emerging economies came under pressure after heavy selling in China's stock market. Those equity declines added to worries about the mixed economic data, the health of the sub prime mortgage industry, and the unwinding of the yen "carry trade".  This involves the borrowing in yen at low interest rates to buy higher-yielding assets, such as emerging market debt. The concern here is that eventually these borrowed monies will have to be repatriated. The decline in world markets seems unwarranted.   The data, such as the durable goods number, tends to be volatile at the tail end of a market expansion. We think the data will rebound in the next few months.  As for China, the fundamentals remain intact. There will be profit taking and growth pains with an economy growing 8%-9% year over year. The Chinese government is trying to control the speculative excesses in lending and investment. It’s important to remember the Olympics are on the horizon. As such, the Chinese government is working towards a healthy China and economic stability in the Asia Pacific region. We think the market sell-off was the result of investors taking profits rather than a reversal in the market’s upward trend.   Elsewhere on the world stage, oil prices are being impacted by the current stand-off between Iran and the U.K. over the detainment of British naval personnel.  As the dispute continues to escalate, it will be important to keep close watch on the region’s flow of oil and the ramifications it has on our economy.   The Concerns of the Fed   Clearly, there is uncertainty in the direction of the economy. We are of the mind that the Fed’s primary goal is to control inflation. They are not looking to bail out the housing sector, the sub prime market, or focus on growth. The markets are efficient and we are already seeing proof of this in the sub prime arena. Accredited Home Lenders, a sub prime lender, received a 5 year $200 million loan with an interest rate of 13% from hedge fund Farallon Capital Management. We believe the Fed does not have the latitude to lower rates. There is still too much liquidity in the stock market. Hedge funds, private equity and leverage buyout firms are announcing bigger deals at larger premiums, every day. This is inflationary. Furthermore, Treasury Inflation Notes, a good gauge of inflation, continue to climb. This is why we started buying them in many of our client’s portfolios well over a year ago.    What Does This Mean for Your Portfolio?   We choose to take advantage of the uncertainties in the market. As we claimed in our last two newsletters, we like stocks. Valuations are especially attractive in large cap stocks. The focus for our clients will be on what has been working for us over the last 3 quarters…with a couple of adjustments.   The U.S. stock market has underperformed compared with most of the equity markets around the world. Given the record money flow into foreign markets and rising interest rates overseas, we think the U.S. stock market could outperform foreign markets over the next year. We will focus on strategies and sectors that are defensive in nature. We are sticking with our view of a weak dollar and a strong euro. We would continue to buy the euro given the large U.S. trading imbalance and the world’s hunger for our treasuries.   We would buy gold and add to positions on price dips. We like gold as a hedge for geopolitical risks. Investors can have exposure to gold and other commodities through mutual funds, closed end funds and exchange traded funds (ETFs). For our clients, the prudent course is to take advantage of low volatility strategies and move from risk toward quality.    High quality stocks and bonds will remain our focus in this market environment. With the Fed on hold we will be quick to take profits and cut losses in this market environment. We suggest selling financials, technology and energy into market rallies. We are continuing to overweight multi-national industrials, health care, utilities and telecom. A weakening dollar and continued global growth supports our choices in the multi-national industrial sector. Additionally, we like the dividend growth that helps minimize the volatility of the sector. Our other focus sectors are also defensive in nature but have consistent earnings growth.   If you have money under the mattress and you’re looking for income, there are a few investments we are placing in portfolios. We have been buying preferreds. These are bonds packaged and traded like stocks which have attractive yields. In addition to current income, it can be an attractive total return investment if the economic downturn materializes. As we have said before, stick with quality issuers.   INDEXING - The Times They Are a Changing   Over the last few years many active managers have exceeded their benchmark, but the environment is now changing. As corporate profits continue to slow, fewer and fewer companies will be able to outperform the broader indices. Over the next 2-3 months, we will continue to migrate our clients’ portfolios into lower cost, low turnover sectors and index funds. Our careful selection of managers will factor in growth deceleration as we look to manage money at a lower cost, resulting in improved performance. Indexing, designed to be a buy and hold strategy, will be taken to new levels by focusing on preferred sectors based on our research and our standing in the economic cycle.   Reasons to be Positive   I was impressed by the volume of the markets after the March Fed announcement.  I suspect more money will come into the market from pension funding and IRA accounts. Also, the luster has worn off the real estate market. Money should now flow from real estate to the stock market. We first mentioned this in our January 2006 newsletter. In addition, U.S. stock valuations are at a 10 year low. On a global basis, the U.S. stock market has not been one of the best performing markets over the last three years and so there is investment opportunity to be had. Tax rates too, are relatively low on a global basis, short term interest rates remain high and there is still plenty of money looking for a home.   Take Action   As I have mentioned in my last three newsletters, now is the time to refinance. Short term interest rates are above long term rates. When I first approached our clients it was right before rates were at historic lows. If you have an equity line, convert it to a fixed rate loan or consolidate it into a first mortgage.   If you have an adjustable rate loan don’t wait until your next adjustment period…refinance now.  As real estate prices continue to slide it will get harder to consolidate your liabilities- credit cards, equity lines and other debt. It’s also worth noting, that we’re starting to see lenders scrutinizing appraisals and homes being appraised lower than the stated value. Most people have the majority of their assets in real estate and are under funded in their retirement plans. I have a strategy to help fund your retirement. I will custom design a mortgage to help you reach your financial goals. Also, I would reevaluate your overall exposure to residential real estate. Congress is now looking at guidelines to propose tighter lending standards on unconventional mortgage lending. The time to act is now.   It is time to fund your IRA. Contributions can be made for the tax year 2006 until April 17th, not including extensions. This includes both traditional and Roth IRAs. The limits are $4,000 for each tax year (2006 and 2007). If you are 50 or more, contributions are $5,000 for each tax year. Click here for more information on Roth and traditional IRAs. Click here if you are a client of Karp Capital.   If you are a business owner please call us to review your current retirement plan. There might be plan designs that can reduce your taxes and help you save for retirement. We are finding many plan trustees who are not aware of the new regulations under the “Pension Protection Act of 2006” and how it can affect your plan. Please click here for more information.   Please remember that we appreciate your support and 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 Karp Capital Management Corporation Registered Investment Advisor 2269 Chestnut St #308 San Francisco, CA  94123 (P)(415)345-8185; (F) (415)869-2832 peter@karpcapital.com   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 and income arising there from can fall as well as rise; the investor may get back less than what was invested; and no assurance can be given that any portfolio or investment described herein would yield favorable investment results.  We or our associated persons may act upon or use material in this report prior to publication.  This document may not be reproduced or circulated without our written authority. 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