It is Always Darkest Before the Dawn
Economic indicators shifted dramatically in the first quarter, signaling changes in the economy. The sub prime mortgage crisis, exacerbated by the decline in housing prices, showed no sign of improvement. As a result, negative reverberations were felt throughout the economy. Ownership of defaulting sub prime securities remains widespread among institutional investors. The casualties continue to mount, from domestic banks and brokerage firms, to global institutions. What's more, the sub prime crisis is affecting prime securities. The financial crisis has morphed into a general liquidity crunch with banks withholding credit from many worthy borrowers. Credit is the life blood of any financial system. It is a leading indicator of the health of the U.S. economy as it is for the rest of the world. The credit crunch is slowing our economy and the impact can be seen in the retreat of stock prices here and abroad. In addition inflation is elevated with high energy and food costs a concern. The questions are numerous. Are we in a recession? Is the Federal Reserve doing enough to help the economy? What are the biggest challenges ahead for the American people and businesses? How will we know when things are improving? In this installment of the Karp Capital Focus we will attempt to answer these questions and look at ways to best position our clients' assets in the first half of the year.
Here are the performance numbers for the major indices for the first quarter of 2008 and for 2007 (as of 3/31/08 total return)
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The best performing S&P 500 sectors for the first quarter of 2008 were Consumer Staples: 7.14% Materials: 6.37% Industrials: 5.45%. Stocks underperformed Bonds by 13.3 percentage points in the first quarter. In addition, Growth lagged Value across size categories. Source: Barrons and ML Equity Research |
Economic Outlook
Many believe the U.S. economy is already in a recession. The definition of a recession is two consecutive quarters of negative GDP growth. The economic data says this is not the case. Unemployment is too low, wage growth is still relatively strong and capital investment is robust. Strong export growth from the weak dollar and the resilience of consumers has helped maintain economic activity, but still, consumer confidence is waning and is at a 5 year low.
The data does not tell the story in this case. The March consumer confidence index fell below estimates. The expectation component of the index plunged to 47.9 from 58.0, hitting the lowest level since December of 1973. It's impossible to ignore this grim reality. If it continues, it would signal a negative number for consumer spending in the near future. With so much weight given to this trend, it's possible we could even talk ourselves into a recession. Businesses and consumers will eventually succumb to the pessimism that surrounds them. In a Wall Street Journal poll, people were asked if they are better off or worse off than they were 4 years ago. 34% said they are better off, while 43% said they are worse off. Keep in mind that consumer spending makes up 70% of GDP. How can anyone blame the American consumer? We've seen the Fed rescue the remains of Bear Stearns through JP Morgan and other financial institutions with little attention to the consumer. While the Fed has lowered interest rates again and again, little effort has been made to help the consumer through these difficult economic times. The stimulus checks due out in May could be nothing more than a quick fix. The overriding question remains to be answered; will the checks go to supplement the higher cost of living, just pay down debt or be used for new goods and services?
U.S. consumer confidence has been undermined. We no longer trust those in charge. Will the Federal Reserve and our government turn the ship around, or are we destined to continue on our present course? Are the Federal Reserve and the administration ready to find creative solutions to revive the economy? We expect stimulus efforts by the Federal Reserve and Congress will begin to gain traction in the coming months. The intended result will be an increase in lending and borrowing, eventually rebalancing economic activity.
We believe economic recovery is on the horizon, perhaps as soon as 10 to 12 months away.
The Fed to the Rescue
Bernanke's Fed is being put to the test as the lender of last resort. The Fed is operating in uncharted waters and they now seem to realize the severity of the economic reality. First and foremost, the Fed and the treasury need to promote economic stability.
Since August, the fed funds rate has been cut 300 basis points, or 3 percentage points. The lowering of interest rates has yet to show material effect on growth, largely due to the credit crisis that has turned into a credit crunch. Lenders are hoarding their cash. They fear consumers will walk away from their financial obligations and mail them the keys to their homes in the face of declining home prices. Thankfully, the Fed and Treasury have awakened to this very real concern. The unconventional monetary and fiscal tools now being used are unprecedented. The Federal Reserve has created the Securities Lending Facility, a new program where it will lend up to $200 billion in U.S. treasuries to banks and brokers for 28 days. The loan will be in exchange for other securities that can serve as collateral, such as federal agency debt and residential mortgage backed securities.
In other words, the Fed is swapping U.S. treasuries for mortgage backed securities that no one else wants. This creates tremendous liquidity in the market and a true confidence boost to the system. This also encourages lenders to lend and not hoard their cash. The program applies to brokerage-investment banking firms as well as banks. Lehman Brothers and Goldman Sachs have already used this facility. Since the brokerage community prides itself on free markets, a line has been crossed that was once unthinkable. Perhaps this can be taken as a sign of upcoming regulations in the brokerage world. Furthermore, the program does not contribute to inflation fears because the Fed will not be adding any money to the system. More dollars injected into the system could ignite price levels for consumer goods. Another measure by the Fed is relaxing the capital requirement at government sponsored agencies; Fannie Mae and Freddie Mac will help liquidity in the mortgage market. This will allow another $200 billion of capital to be freed up to help facilitate lending for homeowners. Even with all of these measures, the Fed must stay on the offensive. There is a heavy period of adjustable rate mortgage resets coming up in May through July of 2008. This might increase the number of defaults and put further pressure on the lending establishment. Now that the Fed is being proactive and creative, we believe much of the risk has been removed from the market. In the past, when the Fed has pumped money into the system it has been a tremendous stimulus to the market. We look forward to the opportunity this presents.
Inflation or the Start of Deflation?
The Fed now states "inflation has been elevated and some indicators of inflation expectation have risen." Looking forward, inflation risks are overblown. Inflation is running a little higher than the Fed's comfort level. Inflation has started to moderate as the economy slows. The true components of inflation are turning downward. The credit crunch has slowed down the velocity of money. It is hard to grow the economy without free access to loans and capital. Also, consumers are spending less and starting to pay down debt. This self examination by the American people is actually deflationary and takes money out of the system. Another indicator
is the lack of pricing power by companies in regard to selling finished goods. Global competition has made it impossible to raise prices. We are also seeing weakness in the labor market. As unemployment rises, wage gains will slow, eventually driving down core inflation. The Fed was behind the curve when it came to lowering rates. The economy started to slow over a year ago. Keep in mind inflation is a lagging indicator and tends to persist at the end of market cycles. As long as wages stay flat, inflation is not the issue, it is the potential for deflation that is of concern.
Investment Strategy
The tendency to buy high and sell low creates turbulence and in turn opportunities arise. Taking action in these times is difficult and sometimes uncomfortable. The flip side is a properly positioned portfolio which can yield significant rewards. In March, the market stood up well to a flurry of bad news while rallying stronger than expected. This reflects short term pessimism yet buying power for equities does exist. As we stated in previous Karp Capital newsletters, volatility, which stems from uncertainty in the economy, has spread to all asset classes and international markets. Volatility works in both directions. This is where the opportunity lies. The ability to dollar cost into our focus sectors and strategies allows us to establish investment positions at an attractive basis. We will continue to focus on high quality assets here and abroad while looking for the emergence of new market leaders. The market is trying to find a bottom. We suspect the market will head higher as it finds new leadership.
The Bond Market
Searching for income in the current credit environment is like walking through a minefield. Treasury prices rise as investors continue toward a flight to quality. We believe treasuries are over valued and now is the time to look through other sectors of the bond market that have been unfairly downgraded. It is time to look through the credit rubble for value.
We stress sector and security analysis as crucial, given our outlook for more casualties of the credit crunch like Bear Stearns. With our 'take' on inflation and asset deflation, investors ought to purchase bonds of high quality for the majority of their portfolios. We believe it's time to add exposure to high yielding bonds and financials for investors who can handle price volatility and have a long term investment strategy. In addition, we continue to add to our TIPS (treasury inflation protected securities) as a hedge to our outlook on inflation. The recent pullback in the price of TIPS has created an alternative to treasuries.
The instability of the sub prime market has taken a toll on the bond insurance companies. Insurance companies are spreading their potential losses over their other insured bond sectors. Given the turmoil with bond insurers, an opportunity is created to buy municipal and agency bonds at a discount. When buying any bond it is important to focus on the underlying assets and revenue of the bond issuer. Call us to review your bond portfolio to optimize your income stream.
The Opportunity
Given the backdrop of our economic outlook and market environment, how should we position assets moving forward? On the equity side of our portfolios, the focus needs to be on international holdings because foreign market capitalization is growing. Therefore we are shifting some of our U.S. assets to non U.S. assets. Labor costs are less in many overseas markets, profit margins are higher and financial balance sheets have improved dramatically in recent years. However, we are not completely sour on U.S. equities. Insider buying of corporate stock is very strong by historical measure and the Fed's unprecedented injection of dollars into the economy is impressive. In addition, sovereign funds (overseas capital) buying parts of U.S. companies creates a price floor in the market. Our concern is that the consumer is taking a vacation from spending and so corporate profits will weaken. We want to focus on commodity producers overseas (Brazil, Canada and India). Our general view of the market has not changed. Most of our portfolios are performing exactly as they should in an increasingly volatile environment. High quality companies are outperforming low quality assets and large caps are out performing small caps. We would continue to stay away from the financial sector. We have stated in past releases that one of the signals of a market bottom will be the consolidation of the financial sector. The demise of Bear Stearns is just the appetizer for the main course. We continue to believe in the global demand story and would buy commodities on any pull back. Hedge funds need to sell securities to unwind their debt. This has been a good place for hedge funds to raise capital. Their loss is your gain. Given our prediction for corporate profits to slow down we would be adding to our healthcare and consumer staples holdings. Additionally, we think technology has bottomed and would enhance our position. We are taking profits in oils and initiating a position in cyclical sectors, such as railroads. The complexities of the market environment test the skills of the most seasoned money manager. It is more important than ever to have a disciplined investment strategy. Call us if you have any questions on the markets or would like a portfolio review.
Housing Market- Where is the Bottom?
If you regularly read the Karp Capital Focus, we don't need to remind you that we have been extremely bearish about the housing market since the winter of 2006. As housing prices tumble we're frequently asked when we will see the bottom.
Real interest rates are still high versus the price decline in homes. We still see substantial downside risk. There will be a time to buy as an investment, but not now. The good news is the rate of decline in sales is slowing. At the beginning of the slide in the housing market it was simple, too many homes and not enough buyers. Now the problem is compounded given home owners with little or no equity are having trouble refinancing out of adjustable rate loans. With home prices falling and payments rising, homeowners are walking away from their homes which add to the supply. This is no longer a sub prime loan problem. Stabilization will occur when the cost of renting is similar to paying a mortgage. When declining home prices become significant enough to entice buyers, this will rectify the current imbalance between supply and demand. The current inventory of homes stands at 9.8 months. It is our opinion at the current level it will take at least 8-12 months to work down the inventory to normal levels.
No Time is Better Than the Present-Retirement
It is time to take inventory of your retirement. Are you on track to reach your income goals? How much money do you need to supplement social security? If you are 5-10 years from retirement, now is the time to start determining how you will go from the accumulation phase of saving for retirement to generating a life time income stream. If you are counting on personal investments and/or a home sale to produce income as you enter retirement you might have to adjust your spending when you start to draw income. Typically, investors are taught to think long term, and not worry about the financial ups and downs that happen in any given year. We disagree with this thesis. Big moves over a short period of time, particularly in the first few years of retirement can have a significant impact on whether you have enough money to reach your income needs. There are 5 major risks when you begin to take income from your investments:
- Poor market performance
- Volatile equity markets
- Low interest rate environment
- Investor behavior (buy high and sell low)
- Outliving your assets
Some risks can be managed or insured away. Controlling these risks is imperative
click here to learn more. Monies taken out on a consistent basis during retirement cannot be reinvested to take advantage of the long term bull market in stocks. We recommend looking at these projections annually and not reacting to returns over a shorter period. Pensions are disappearing with the risk of generating income being transferred from your former employer to you. Rather than take on the responsibility yourself, call us, and we will be happy to design a retirement income proposal to suit your needs.
IRA Funding
It is that time of year again. It is not too late to fund your IRA for 2007. Contributions can be made to your IRA until April 15, 2008. Traditional and Roth IRA contribution limits are $4,000 ($5,000 if you are 50 or older). Even if you cannot deduct your contribution, it is a good idea to contribute for the tax deferred growth. Consult with your CPA on IRA deductibility or click here to download from our web site the 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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