A Wild Ride
The markets of 2007 can be characterized with one word… VOLATILITY. The broad U.S. stock market produced a positive return to start the 4th quarter. On the 18th of September, we were surprised by a 50 basis point rate cut instead of the expected 25 basis points. The markets embraced the Fed’s new understanding of the dire need to respond to the upheaval in the credit markets and signs of a deteriorating U.S. economy. The rally, however, was short lived and November saw a correction across U.S. and international markets. At Karp Capital our portfolios turned in smaller losses given our over weighted exposure to healthcare, consumer staples and utilities. In addition, treasuries and high quality dividend strategies benefited from a flight to quality and the increased odds of a significant economic slowdown. With declining earnings predicted, the current credit crunch and commodity price increases, we believe we have uncovered unique opportunities. We will discuss the roll of the Fed and how the focus has changed from just the Fed to include corporate financial institutions. We will look beneath the avalanche of economic data to uncover what is truly important and make our forecast for 2008 to best position your portfolios. Despite what the markets are telling us, we remain cautiously optimistic for the coming year.
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 fourth quarter of 2007 and year to date as of 12/31/07 (Total Return-dividends reinvested)
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The best performing sectors for 2007 were Energy: 28.85% Materials: 16.46% Utilities: 12.28%. Bonds outperformed Stocks in 2007. This is the fifth annual out performance by treasury bonds so far this decade. Gold out performed all three major asset classes (bonds, stock, cash) for the third consecutive year. Source: Barrons and ML Equity Research |
When Bad News is Good News
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 create a cloudy inflation picture. Will a slow down in growth deflate prices or will global demand from China, India and emerging markets put upward pressure on prices? 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.
Oil
Given the supply and demand equation for this limited resource, there’s no reason to believe that oil prices won’t escalate in 2008. Even in a global slow down, the possibility of a supply shock exists. With Iraq making up the world’s third largest oil reserve, fears of supply interruption (brought on by Turkish air strikes and violence by militants in Nigeria) have caused a December rally in prices. As a result, we carefully monitor the ever-shifting headlines and continue to buy integrated oil and drilling stocks on weakness.
Weak Dollar
The U.S. dollar will continue to weaken in 2008. If the Fed continues to lower interest rates, the dollar will continue to fall. Taking this into consideration, we would add to our euro and other developed nations’ currency holdings. In addition, we have used gold as a hedge to the falling U.S. dollar. Of further concern, there have been discussions among OPEC nations to diversify their dollar holdings. For years they have pegged their currencies to the U.S. dollar. If OPEC diversifies away from the dollar, it could undermine the overall demand for dollars. This is a very real concern as Kuwait has already switched to a basket of currencies.
Ground Hog Day
What is our investment outlook for 2008? A few investment forces of 2007 will continue to have an impact on the economy and the markets in 2008. Bernanke’s Federal Reserve will continue as a focal point for investors. The Fed generally controls only the base rate of credit. Simply put, they are able to affect short term interest rates. Mistakenly, investors will continue to hang on every action and statement of the Fed. We believe the Fed is in uncharted waters and to rely on the actions of the Fed in our investment thesis would be misguided. In 2008, financial institutions will still struggle with the sub prime crisis. Banks, brokers, and other financial institutions will continue to write down billions of dollars of loans and restructure their businesses to survive. These credit issues are deeply embedded in these financial institutions. Writing off bad debt is not enough to turn around this sector. Additionally, home prices will continue to fall in the majority of U.S. cities. On average, prices were down 6.1% in the past year (as of October), according to the Case-Shiller price index released the middle of December by Standard & Poor’s. The 30 year fixed rate mortgage now is just over 6%. That means the implied mortgage rate is almost 17%. Buyers are on the sidelines. Why would you borrow money to buy an asset that is depreciating? Until potential buyers can believe that prices will not fall further, home sales will continue to decline. Additionally, we believe borrowers will continue to struggle to find available credit to buy homes. Historically, housing corrections take a long time to stabilize and turn around. After the market softened in the late 1980s, sales fell for 5 years, and then took three more years to return to peak level. October marked the 10th consecutive month of negative returns and the 23rd consecutive month of decelerating returns. In other words, we choose to stay away from residential real estate as an investment.
Opportunity Knocks
Globally, we see an economic slowdown and not a recession. Many foreign central banks have been contemplating raising rates to stem inflation pressures. We think the tide will turn and rate cuts will be necessary to stimulate growth. This is an opportunity to purchase small to mid-size stocks overseas. In our last newsletter we stated that inflation might not be as prominent as once thought. As oil approaches $100 per barrel and other input commodities are at record highs, we’ve changed positions. Inflation will be an issue in the coming year. So why be optimistic? Given our deteriorating outlook of the global economy, why are the markets going up? The answer lies beneath the economic data. First, it is because the market cap weighted indices are global in make-up. 40% of the Dow earnings and 50% of the S&P earnings are generated outside the U.S. In addition, the global economy has forced U.S. companies and workers to be more competitive. Because of this, U.S. companies use fewer commodities in production and so costs are lowered and profitablity is higher.
The Bond Market – A Search for Income
Treasury prices continue to rise and yields fall as investors worry about the state of the economy. Income investors have had few attractive choices for the last couple of years. If you searched for additional income, the risk to reward ratio was dismal at best. The extra yield over treasuries paid on riskier bonds (known as the bond spread) reached historically low levels during the early part of 2007. This happened as the credit markets/subprime fallout hit its peak. The credit market debacle has created an opportunity to reach for increased income, as there has been a flight to quality in treasuries. We think it’s time to add some exposure to high yielding bonds for investors who can handle some price volatility. For the majority of a bond weighting in a portfolio, we want to play defense. Municipal bonds, high grade corporate bonds and preferred stocks are likely to outperform treasuries in 2008. We like closed end bond funds selling at a discount to net asset value for extra yield and municipal bonds. If the economy continues to slow, tax revenue will decline and municipalities will have to raise money to make up the shortfall. This thesis unduly put pressure on the municipal market at the end of the year. Quality issues were marked down unjustly. We would be buyers in this weakness. Call us to review how we can create income from your investments.
Taking Action
Our investment strategy for 2008 stems from our outlook on the markets of the global economy. Our core philosophy is to avoid needless risk. The key is not to eliminate the risk, but don’t take risk you don’t get paid to take. In 2007, the risk was in plain site. We found it impossible to build a case for home builders, financial and retail related stocks. We will continue to avoid these sectors in 2008. Over the last quarter, we have seen an up tick in volatility and negative market sentiment. What are the markets trying to tell us? For us, it is adding to our focus sectors and aggressively managing our portfolios with rebalancing strategies (taking profits and being patient). We will focus on large cap stocks over the small and mid cap sector. We will also steer clear of value style investing and focus on growth (85% of the value index is comprised of financial related stocks). We continue to be bullish on owning hard assets. The price of gold has jumped above $800 an ounce from $650 in August. This is an indicator that an increasing number of investors are losing faith in the U.S. dollar as a store of value. Also, we want to hedge our portfolios by adding contrarian sector exposure. We are adding biotech to our clients’ accounts. The performance of biotech companies is generally independent of the economy. As many blockbuster drugs come off patent, drug companies are starved for new drugs to market. We are also adding to our technology allocation and continue to add to our healthcare exposure. As always, we remain focused on companies and sectors that have strong balance sheets and are focused on growth.
Predictable High Quality Income
Given the interconnections of markets and deceleration in earnings, it is more important than ever to have a disciplined investment strategy. Our focus will remain on high quality dividend strategies. We have and will continue to add to our utility holdings. This includes telecom and utilities that have exposure overseas and in alternative power. If we are right and the 10 year treasury note falls to 3.65% by the end of 2008, these sectors will rally.
Financial Plan or Financial Pain?
This is a very important question which needs to be addressed by everyone. Simply put, a financial plan is the road map that will get you where you want to go. That may be retirement, college planning or any number of other goals. A plan lays out the steps needed to get started. It maintains the path and, most important, provides a way to measure results to make sure you are on track, or if any adjustments need to be made. It allows you to relax, secure in the knowledge that there is a formulated, mutually agreed upon strategy in place to keep everyone focused on the outcome and not the little bumps along the way. Call us to develop a “road map” to REACH your financial goals.
IRA Funding
Remember NOW is the time to fund your IRA. Contributions can be made to your IRA for the tax year 2007 up until April 15, 2008, not including extensions. Traditional and Roth IRA contribution limits are $4,000 for tax year 2007, $5,000 if you are 50 or older. Visit our website for IRA Funding guidelines.
At Karp Capital we’re here to listen to the concerns of our clients, give sound advice, and execute their financial plan. These attributes make a good advisor a great advisor. If you appreciate this style of financial management and would like to work with an advisor who can satisfy your investment concerns, you have found a home at Karp Capital.
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. 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 KarpKarp Capital Management
Corporation |
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