Take a Walk on the Wild Side
During the second quarter of 2007 the markets went on a “wild ride” effected by conflicting data and a flurry of leveraged buyouts, mergers and acquisitions and company stock buy backs. The markets have staged a broad based rally leaving many institutional and individual investors scratching their heads over the unprecedented market surge. As we end the quarter and enter the earnings season are we starting to see the reemergence of growth in the economy and tame inflation? Has Bernanke orchestrated a true “soft landing”? We will examine what we learned from the data during the quarter and why we are changing our focus sectors. We see a weakening economy followed by falling earnings and rising inflation, which would discount the future earnings of corporate America. In addition, there are no signs of a bottom in the housing market. For stocks to maintain their recent gains and even rally over the next few months, they need the bond market to stabilize. As a result, we think we’re facing a rising stock market with continued volatility.
Here are the performance numbers for the second quarter of 2007 and year to date as of 6-30-07 (Total Return). Source: Barrons and ML Equity Research.
| 3 Months | YTD | 12 Months | |
|---|---|---|---|
| Standard and Poor’s 500 | 6.28% | 6.96% | 20.59% |
| Dow Jones Industrials | 9.11% | 8.76% | 23.04% |
| NASDAQ - Comp | 7.50% | 7.78% | 19.85% |
| 3-month T-Bill | 1.27% | 2.54% | 5.21% |
| Long Term Treas. Bonds | -2.14% | -1.35% | 5.85% |
| Gold | -1.70% | 2.33% | 6.03% |
At the end of 2006 we stated that this was the lowest level of cash we had in money markets and that we thought the markets were undervalued. At this time the markets are more fairly valued. Our sense is that short term risks have increased in the stock market and the next few months will be more difficult than the previous quarter. This is not to say we don’t see both good and bad in this market.
Margin debt, borrowed money on stocks, as a percentage of the total market value has increased to a historically high level. In addition, the media has been exalting the strength of the Dow and other market indices. On the positive side, corporate America is in the best financial shape in memory. Corporations are profitable with low levels of debt and large amounts of cash on the balance sheet. This certainly lays a foundation on which to build the next leg of the stock market. Also, we are seeing a broad market advance. Though some specific industries are having problems, each of the 10 broad sectors in the S&P 500 is up this year. We think there are market phenomena that will continue as the driving force behind the market rally.
Given the current climate, we expect leveraged buyouts, mergers and acquisitions and company stock buy backs to continue. According to a recent Morgan Stanley report, there was $212 billion worth of M&A deals announced in May, the highest since the peak of January 2000. Add to this, another $75 billion in LBO activity and $33 billion in corporate buybacks and it‘s no wonder the markets have been doing so well.
Will the bond market help or hurt?
It’s our belief that treasury yields will continue their upward trend and, accordingly, our target is 5.5% on the 10 year treasury. This level, however, would not be high enough to sabotage the stock market.
Presently, we are negative on bonds for the following reasons: There is real commodity inflation on the horizon. The media and the high cost of gasoline have pushed energy conservation to the forefront of the consumer’s mind. Governments and large basic materials companies are buying up small and mid size steel, copper, nickel and other raw materials. Consequently there is a worldwide building and infrastructure boom that’s been tempered by a worldwide shortage of skilled labor. China could face a drought of surplus labor as soon as 2008-2009. To make matters worse, worker productivity is flattening out. In the past 5 years we’ve witnessed a weakening in capital spending by businesses. These issues with the massive amount of liquidity in the financial markets make it difficult to be optimistic on the bond market.
Even though we believe there is inflation in the economy, the markets are telling us something different. The spike in rates has not been accompanied with typical inflation barometers such as a rise in gold or treasury inflation notes. For now we will have to wait and see what is truly driving bonds lower. For our portfolios we favor high quality bonds with short to medium term maturities that carry less price movement when rates trend higher.
Inflation
Inflation is an issue I have addressed in each of our last four newsletters. The focus for investors has been only on wage inflation and the cost of housing. The volatility of the food and energy sectors has been stripped away or downplayed from many assessments I’ve studied with regard to the consumer price index. This can no longer be the case because energy prices and food prices continue to climb.
Fed governors wrapped up a two day meeting opting to keep interest rates at 5.25%. Evidently, the Fed is comfortable with the economy, but inflation is still a risk. The Federal Reserve has left interest rates unchanged for 8 straight policy meetings. Core inflation numbers and growth numbers have improved, why step in? Why alter policy? In the Fed policy statement it was made clear that even though the inflation numbers have improved modestly, it is not enough for them to be comfortable with the economic backdrop. We think there will be movement towards higher rates at the beginning of next year.
Attractive Sectors
As the rally in global equity markets continues, we recommend investors tilt their portfolio in favor of global equities and underweight U.S. and foreign bonds. While U.S. and international markets are starting to look expensive, on a valuation basis there are a few sectors we still like. Continued stock market performance will come from sectors and strategies that focus on growth and reducing portfolio volatility. We think market volatility will increase as the year progresses because investors will become more uncertain regarding policies of central banks around the world.
Unwinding of Leverage
The Subprime meltdown that was supposedly contained is coming back to haunt the bond market. Besides Bear Stearns hedge funds having to increase collateral to secure the leverage of the fund, other hedge fund defaults could be on the horizon. Therefore it will come as no surprise when the cost of financing buyouts will rise further. This will take some time to unwind because credit agencies will have to go through the issuers and re-rate the bonds. The question is...will investors demand a higher risk premium for the leveraged investments? If they do, spreads will widen and liquidity will be wrung out of the market. Leveraged buyout activity could slow given the inability to raise capital. This in turn will affect stock prices and make it difficult to refinance existing debt. The good news is that there will be a short term flight to quality, where treasury prices might go up and the yields come down. This could help the consumer with a last chance to restructure their debt, or have a short reprieve from higher rates and payments.
There are five categories of investments that tend to outperform when volatility increases: 1) high quality and large cap stocks 2) defensive sectors like consumer staples and healthcare 3) a more conservative mix of developed and emerging markets 4) High quality bonds 5) dividends and income. We are adding consumer staples to our sector focus, given the predictable earnings and the defensive nature of the sector. We will continue adding to our industrial weighting given the worldwide growth in infrastructure and the weak dollar. Our focus will change by dropping our weighting of telecom and utilities in half. The sectors are expensive and the earnings are starting to peak. This is the same reason for taking profits in the energy sector. Given our view of inflation and current global turmoil, we would continue buying the Euro and Gold on dips.
Why Focus on an IPO?
The IPO of Blackstone was one of the biggest in the financial services industry and among the first U.S. public offerings of shares in a private-equity firm. It has also sparked heated debate. On one hand, the offering represents a rare chance to invest alongside big institutions. However, Blackstone's top executives are afforded massive compensation, and filings show that the firm will incur significant losses as it pays out the founders and makes its transition to the public market. What is all the fuss over a billionaire taking his company public? Congress has never been more interested in the capital raising plans of an investment partnership than it has been in Stephen Schwarzman (Blackstone co founder and CEO). Reps. Dennis Kucinich and Henry Waxman asked the Securities and Exchange Commission to stall Blackstone's $4 billion initial public stock offering. In addition, Sen. Jim Webb asked not only the SEC but the Department of Homeland Security and the Treasury Department to hold up the much anticipated IPO, on national security grounds. On top of that, Senators Chuck Grassely and Max Baucus introduced legislation that would change how companies like Blackstone are taxed. It is the biggest IPO in nearly five years and part of a trend of private partnerships seeking to cash out part of their ownership stakes in the public markets. Why should you care? These private buyout shops have a growing influence on the stock and bond markets. Blackstone, one of the biggest private equity firms, controls more than $80 billion.
Numerous institutional investors, public pensions and now China are in the fund. Why go public? The price to earnings of companies are relatively low vs long term interest rates. This creates the first time in history where the average company can borrow money to buy back their own shares and have their earnings rise. Then they can take the valuation of their company, take over a competitor and buy back more shares. The private equity companies can do the same thing. It is an arbitrage. It is free money to the private equity firms. It is the perfect time to exploit this market structure. These IPOs are priced for the issuer's (seller's) advantage and not for the buyer. The smartest people in the room are selling. When Blackstone Group, (whose timing of the initial public offering in late June was perfect), is selling I don’t know if I want to be the buyer. Stephen Schwarzman and other private equity and hedge fund managers have reached rock star status. Mr. Schwarzman is one of the all time greatest at valuating assets. He only sells when he can command the highest premium for an asset. You don’t want to question his judgment. For that matter why would you want to be on the other side of the trade? Consequently, we will pass on this sector for our client’s monies but we do want to piggy back on what they are buying. While mid caps are rarely the top performing sectors they do tend to be the sector of choice for M&A and private equity deals. Mid caps have superior financial strength and product diversification compared with those of small caps. Also, they have more growth potential than large caps. This is the best way to play the Private Equity Game.
Credit Report Woes
Do you have an error on your credit report that appears irreversible? Have you ever been the victim of identity theft? You are not alone if your answers are yes. For the last five years, identity theft has been the number one fraud complaint filed with the Federal Trade Commission. Identity theft and misinformation on credit reports are connected given the vulnerability of the cyber oriented world we live in. The concern is that so much of what affects us financially stems from our credit report and the corresponding score.
At Karp Capital we handle lending strategies and loan processing for many of our clients. With great concern, I’ve noticed creditor reporting errors, numerous inactive accounts and outright identity theft. These issues need to be addressed before we apply for credit. Sometimes it takes months to fix these items. Congress knows it’s a problem and is addressing it in numerous proposed bills. Both Democratic and Republican lawmakers are calling for the Federal Reserve and the Federal Trade Commission to enact rules under the Fair and Accurate Credit Transactions Act of 2003 that would address the accuracy of information used by credit-reporting agencies as well as the adequacy of the dispute-resolution process. In a 2004 survey, one out of every four credit reports contained serious errors that could result in the denial of credit, according to the U.S. Public Interest Research Group. Why is it so hard to fix and repair your credit? Equifax, Experian and TransUnion are the three major reporting bureaus. The agencies are not interested in ensuring accuracy or responding to the consumer. There is no financial incentive for the credit agencies. They are paid for running the reports. Why should you care? Credit reports contain information about where you live, how you pay your bills and whether you've been sued, arrested or filed for bankruptcy. Some causes of errors in the reports are: mixing the identities of consumers, creditors providing inaccurate information and the fallout from identity theft.
With this in mind, it’s important to know how to use the system for your benefit. The Federal Trade Commission recommends consumers dispute errors on credit reports. Send the credit-reporting company a letter about the information you think is inaccurate. Clearly identify each disputed item and why you dispute the information. Include copies of documents that support your position. Request that the disputed information be removed or corrected. Send your letter by certified mail. Tell the creditor or other information provider that you are disputing an item. Include copies of documents that support your position. Keep copies of the letters and other documents. This process takes time, money and diligence to be effective.
We have another way to help you secure your credit identity. Please call the office to have our credit experts evaluate your current credit standing. PROTECT YOUR GOOD CREDIT. Click here to see how we can help.
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As the markets approach new highs in numerous indices, Karp Capital Management wants to use this opportunity to rebalance portfolios and take profits. We think the securities industry and Wall Street analysts are overly cautious on corporate profits which is understandable given 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 a low cash allocation. Stay invested. |
Please remember that we appreciate your support and we 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. In addition, if you have any questions on the analysis above, or would like to review your portfolio’s performance, please call me at 1-877-900-KARP. Working with Karp Capital, there is only one boss….YOU!. |
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Peter Karp
Karp Capital Management Corporation |
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. Securities offered through Financial Telesis, Inc.