Christmas Comes Early
The third quarter of 2007 began with the unraveling of the lending markets. Sub prime mortgages are defaulting at an accelerated rate and as a result it's freezing certain sectors of the financial markets. The "liquidity crunch" showed us how interconnected and global our markets have become. Liquid assets, (high quality stocks and bonds) were sold off by hedge funds and other leveraged investors to pay back borrowed monies. This helped reduce the risk in the markets. As investors sorted through fact and fiction, monetary regulatory bodies throughout the world worked to calm the financial markets and bolster investor confidence.
The fallout from the mortgage backed securities market permeated the banking community and restricted lending of assets that affect money markets. As a result, investors have now refocused on market fundamentals. Global growth remains robust, inflation and interest rates remain low and manufacturing activity remains solid. In addition unemployment is at a relative low.
Furthermore, we now have a Federal Reserve that realizes there is more risk in recession than in inflation. As a result, the Federal Open Market Committee agreed to cut the federal funds rate and the discount rate by one-half percent. This was an unexpected gift in the eyes of Wall Street. It sent investors scrambling to buy stocks, pushing the Dow Jones Industrial Average up 336 points by the end of that day. It was the Dow's largest one day point rise in nearly five years. As the markets continue to rebound, the leading indices are near the highs of the year. In this installment of Karp Capital Focus we will address what has changed in the economy, the banking system and how it affects the markets and our clients.
Here are the performance numbers for the major indices for the third quarter of 2007 and year to date as of 9/30/07. (Total Return)
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The best performing sectors for the last 9 months were Energy: 19.56% Materials: 12.87% Industrials: 8.11%. The largest companies in the S&P 500 outperformed the smallest companies in the index by over 12% in the third quarter. Source: Barrons and ML Equity Research |
Inflation Fears and the Dollar
What are the markets trying to tell us? Given this quarter's data, I am adjusting my view of the inflation picture. The cross currents of the economy will quell any inflation fears. The U.S. dollar fell to a record low against the euro and the Canadian dollar closed the quarter almost exactly at par with the U.S. dollar for the first time since 1976. What's more, no one at the Treasury Department or the Federal Reserve seems to care. In fact, the fall of the dollar might be a contributing factor to keep the U.S. economy out of a recession. A cheap currency can boost the trade balance by curtailing consumers from buying imported goods and sparking exports. It also makes the U.S. stock market relatively inexpensive and enticing to foreigners. The fear of inflation from a falling dollar seems to be unfounded. The consumer price index is mostly a services price index. Canada is our biggest trading partner and as a result, the falling dollar could potentially boost Gross Domestic Product and preserve jobs. Still, the historic drop in the dollar is a troubling phenomenon. We believe the dollar will continue to fall versus the euro.
Over the past twenty years, the dollar has gone down 2/3 of the time against the value of the euro (this factors in the 11 legacy currencies prior to the introduction of the euro in 1999). This is an indication that currency investors have little faith in the value of the U.S. dollar and the growth of the underlying economy.
Additionally, a weak currency suggests a decline in our standard of living. Cash is losing value. Our major trading partners are divesting out of the dollar into hard assets. Over the past year, we've suggested buying exchange traded funds for the euro (FXE) and the Canadian market (EWC). Given the current financial climate, we see no reason to change our recommendation and would suggest buying more EWC on any price decline.
Looking back on August, inflation data revealed that there was a downward trend in the core rate of inflation. The year over year rate is now just 2.1%. This is at the high end of the Fed’s comfort zone; but keep in mind the rate is falling. Given the tremendous supply of homes, the cost of housing is plummeting. Homes that cannot be sold are being rented. Rents account for 38.5% of the core CPI (per High Frequency Economics). In addition, the cost of consumer goods (clothing & household items) has been dropping over the last year. Inflation protection is built into the global economy. Because of competition, if prices of finished goods go up, consumers can shop the global marketplace for lower prices. Much of the credit can be given to China. We are importing more and more from Asia to satisfy our never ending appetite for low cost goods. Despite recent problems with the quality of Chinese imports, we think this trend will continue and the Fed will again lower rates at their October and December meetings.
The Housing Market - Where do we go from here?
Don't be fooled by the positive media spin and those working in housing related industries. Home sales are falling faster than ever. At the time of this writing, housing starts are at a 12 year low coupled with a lower number of starts which has declined by 50% since May. Sales of existing homes have fallen to a 5 year low. Almost all the data released in the last couple of months has signaled continued tough times for the housing market. Keep in mind we are only 6 weeks from the sub prime mortgage crisis. It will take time for the full effects to filter through the markets. Fallout from the sub prime debacle has caused a surge in jumbo mortgage rates (loans over the conforming loan amount of $417,000). This, of course, affects prime borrowers. Higher end homes have not yet seen the dramatic drop in prices but this could change as underwriting standards tighten, lenders close their doors and loan programs disappear altogether. Lenders can't imagine a worse situation…soaring loan delinquencies and falling home prices. In spite of this, we believe the bottom of the market is still some way off. Our view of the housing market comes from the fact that real mortgage rates in the second quarter of this year stood at 9.6% (from Case-Shiller data). The last time real rates were at this level was back in 1991-92. Given the current supply of houses (estimated at 10 months), home prices could fall 30% from peak to trough to stable.
Bernanke's Federal Reserve
What has history taught us? In July of 1990 and September of 2000 the Federal Reserve eased interest rates by 1.5% and the U.S. economy slipped into recession. What does this have in common with the current economy? It's the unwinding of an asset and credit bubble which signals the start of the deflation process. Despite the best efforts of the Fed by lowering rates, the cycle trends played out.
Brilliant Move
The Fed took control by doing the unexpected…lowering interest rates by .5%. The Fed revised its outlook on the economy by stating "some inflation risks remain". This is a realistic view given the potential drag of the plummeting real estate market. The Fed's perspective is that they bought time to view incoming data as it needs a clearer picture of what's really happening in the economy. The effects of the sub prime mortgage defaults and dropping housing values remains unknown. The action by the Fed puts the Federal Reserve ahead of the economy instead of being reactionary. Keep in mind the Fed's move will do little for the housing market. Fed policy and interest rate cuts will only help dampen the effect of the real estate fallout on the broader economy. We think the Fed is on the right track but the consumer needs to be prepared for difficult times ahead.
It is a Small World After All
Why should investors care at this point? If you are able to identify where we are in the economic cycle and able to interpret monetary policy you can position your investment portfolio to reduce risk and increase return. Fed policy is forcing the consumer to consume less in order to reduce the excesses from the past few years. There are three basic ways to reduce consumption: raise taxes, raise interest rates, or make goods and services more expensive so people consume less. Going into an election year, the third option is the most acceptable. Taking this into account allows us to formulate our core investment strategy for our clients. The stock market has been durable and has been moving higher in the face of negative data on the economy. We have been bullish on owning hard assets. Gold prices are up and at its highest level in nearly 28 years. Wheat and other input commodities are at multiyear highs with oil also at record highs on a dollar basis. We see no reason to stop adding to these sectors and we choose not to fight the Fed. Even though we are optimistic on the stock, bond and commodities markets, we still focus on risk adjusted returns for our portfolios. What happens if the fear of recession comes to fruition? What if the U.S. economy slips into recession and the interest rate cuts don't curtail the real estate debacle? What if unemployment moves higher and consumer spending slows? How do we structure our portfolios to weather and thrive in this economic environment? We want to hedge our portfolios by adding contrarian sector exposure. We continue to add large cap multi national companies that pay dividends, high quality bonds and industrials. We are rebalancing our international weightings from emerging markets into large cap stocks in developed markets. In the U.S. market we are holding steady with our technology allocation and continue to add to our healthcare exposure. We also remain focused on companies and sectors that are flush with cash and have strong balance sheets. Given our view of housing and the mortgage market, we would take the opportunity to sell financial stocks into any market rally. In addition most consumer stocks should be avoided. Retailers are worried that rising fuel prices, low home values and rising food costs will crimp holiday sales. Given the complexities of the market environment it is more important than ever to have a disciplined investment strategy.
The Bond Market
What is the bond market telling us? The yield curve has steepened dramatically over the last month with an upward sloping curve that signals a healthy economy. Short term interest rates are lower than long term rates. Investors receive higher interest rates for locking in longer term bonds. The move from a flat-inverted curve to an upward sloping curve seems to signal that the economy will be strong and inflation is moderating. Then why is this contrary to the current state of affairs? Something must be happening. Investors are buying into the fact that the Fed will not re-inflate the economy and we will side step a recession. Simply put, I think this is too optimistic. Now is the time to be defensive; we should buy municipal and high quality bonds in the 10-15 year range. The yield curve, in our interpretation, is signaling an economic recovery in 2009 but not until we pay for the artificially low interest rates and excess liquidity (easy money) of the last few years.
Take Action
In recent years high net worth clients are relying more and more on the equity in their real estate for future retirement income. We see an uncomfortable trend as we sit down with new clients and prospects. There are inherent risks with real estate investment as a retirement funding source. In the past, primary or secondary residences were considered an illiquid asset. These homes were considered places to live, raise a family and pass on to the next generation. The goal has always been to pay off your home. Times have changed, given that residence debt is more favorable from a cost and tax perspective. This, in combination with the unprecedented rise in real estate values has changed the behavior of investors. Home owners have taken on larger debt levels as values have increased and retirement savings have fallen. The fact that price appreciation is not guaranteed is now entering the equation, as is its illiquid attribute. Given the cost of homes in most metropolitan areas, it is easy to over invest in real estate as a percentage of your overall portfolio. As I have mentioned in past issues of Karp Capital Focus I urge you to evaluate your real estate holdings. This is a great time to downsize, particularly if you are an empty nester. Also it is not too late to sell or exchange investment property that does not maximize your equity. Remember, I am available to help you make these investment decisions in the context of your overall investment plan. Is it too early to start tax planning? No! Now is the time to review your portfolio to help reduce your overall tax burden. Given the market volatility in 2007, tax loss selling can be used to offset realized gains in your portfolio. This involves swapping out of a security to lock in a loss and purchasing a similar security to maintain asset allocation and diversification. We recommend implementing the strategy early in the quarter instead of waiting for the end of the year. In addition, we are finding opportunities to take losses on bonds and increase portfolio income by doing bond swaps. Please call us to review your portfolio and see how we can help you lower your taxes by implementing these strategies.
Business Retirement Plans and Compliance
At Karp Capital Management we work with business owners and trustees to help provide retirement plans that fit the needs of the business and the employees. You might be surprised to know that most plans change providers not because of investment performance but because of administration and lack of attention from the provider. The ERISA Health Check performs a comprehensive compliance audit of your retirement plan. Designed to detect systemic weaknesses in governing documents, administration, and investments, an ERISA Health Check operates on the same premise as a traditional health check; the sooner you detect and address weaknesses, the better your odds for a favorable outcome. Uncle Sam rewards this diagnostic behavior. Most plan sponsors review and make plan changes at the end of the year. Click here for more information.
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Peter Karp
Karp Capital Management Corporation |
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