The Perfect Storm

It was with relief that investors greeted the end of the quarter; the first half of 2008 was behind them. The U.S. economy continues to struggle, weighed down by the combined effects of three financial factors: the housing slump, the banking liquidity crisis and the global acceleration of energy and commodity prices. The markets are in need of good news to spur a rally but, instead, are met with disappointment. Stocks, bonds and commodities still trade in a volatile fashion. Traders’ hopes have been dashed with the market trading lower than the lows set in January and June.

The Federal Reserve seems to be caught between two camps; should its focus change from combating recession to reigning in inflation. These cross currents present new challenges in managing our clients’ financial goals and investment strategies. There are several big questions on the minds of investors. When will we see the light at the end of the credit crunch? What do higher oil prices mean for the economy and society in general? What affect does November’s election have on our investment outlook? As we enter the second half of 2008, we find ourselves in interesting times with new opportunities and a sense of change in the air. We’d also like to thank our clients for their part in helping us make San Francisco’s Business Times’ list as one of the top 25 financial advisors in the Bay Area. Your success is our success.

Here are the performance numbers for the major indices for the second quarter of 2008 and year to date (as of 6/30/08 total return)

Economic Outlook

We believe the economy is in a state of stagflation since the government doesn’t take into account food and energy prices when reporting the core consumer price index (CPI). When those prices are factored in, the measure of the CPI is elevated above the Fed’s inflationary comfort level.
Even so, labor markets have softened with payroll growth turning negative. Additionally the unemployment rate continues to rise. Consumer sentiment is at a 28 year low, partially because the consumer is not able to access monies through traditional credit sources. Home values, too, are falling and basic necessities such as gas and food are climbing. Since the consumer makes up seventy percent of the gross domestic product, this does not bode well for positive growth in the U.S. economy.

We believe the consumer will experience upward pressure on commodity prices over the next two quarters. In addition, we see tighter credit conditions and a further downturn in the housing market. If these events continue, consumers will have less money in their pocket, less flexibility and the economy will cease to grow. Without the stimulus checks from Uncle Sam there would be negative growth in the economy. For most of corporate America, profit growth will continue to slow in the near term as the economy struggles. In the past few years, profit margins were healthy but global competitive pressures and slowing sales strained profits. With these economic factors in mind, we are able to form our investment strategy for the second half of the year.

Change that Tune

This is a difficult environment in which to set monetary policy. Is the Fed focused on revitalizing the economy, stabilizing the housing market and/or controlling inflation? Federal Reserve chairman Ben Bernanke told a congressional committee that the U.S. economy is unlikely to grow much, if at all, over the first half of 2008 and could even contract slightly. But, on a more positive note, he “anticipates strengthening in the second half of the year.” Is the chairman being too optimistic? We believe his optimism is cause for concern, especially given his focus on containing inflation at the expense of the housing market. This does not set the stage for economic recovery. According to a report by the Pew Charitable Trusts, one in thirty three of the nation’s home owners will go into foreclosure over the next 2 years as a result of resetting mortgages on sub prime loans made in 2005-06. It appears that the American consumer now knows they are in trouble. The Fed needs to finish the job of economic stabilization before raising interest rates to protect our dollar and control inflation. The Fed’s rapid fire rate cuts have been a factor in the dollar’s decline. This in turn, has helped fuel the rise in oil and most commodity prices. The Federal Reserve doesn’t want to go through a 1970s inflationary cycle. Bernanke stated that, “policy makers learned a lesson in the 1970s, in particular, that they must keep long term inflation expectations anchored to achieve low and stable inflation.” We expect the unexpected. After the election, be prepared for a possible interest rate increase.

Politics and Your Portfolio

Who do you want in the White House this November? One thing is certain; the next president will have an agenda that will affect the markets. Historically speaking, the stock market has performed better with a democrat in the white house than a republican. Also, history has shown that the first two years of a presidential term are the worst years for the stock market, but you could certainly expect that any policy that favors fiscal expansion would be better received by the stock market in the short term. If Barack Obama is elected, it is widely assumed that the ethanol mandates and federal subsidies would likely continue since southern Illinois is a major corn growing region. Obama would probably protect his home state subsidies. If John McCain is elected it is expected that the ethanol subsidies would be cut off and the demand for less expensive Brazilian ethanol would increase. This further supports our investment thesis of having a position in commodities and in Brazil.

With regard to stimulating growth and paying for legislative programs, Obama and McCain are on opposite sides of the issue. McCain wants to extend the reduced tax rates on capital gains and dividends set to expire in 2010. McCain’s plans will stimulate the economy but will also increase the deficit. In contrast, Obama favors an increase in tax rates of long term capital gains to at least 20% from today’s level of 15% for most investors. The question is, does raising taxes increase growth in the economy? The chances are, your taxes will be going up. This plays into our investment strategy of positioning portfolios in our focused sectors and adding or selling around core long term investments given market fluctuations. This allows us to use market volatility to our advantage and reduces taxes.

If Obama’s tax plan became law, investment professionals agree that the biggest winners would be tax exempt municipal bonds, (issued by state and local governments). Typically, these bonds benefit when ordinary income-tax rates rise. McCain, for his part, wants to make permanent the current federal income tax rates. He also opposes Obama’s plan to lift the earnings cap on the social security payroll tax.

Main Street, is the Consumer in Trouble?

The sub prime mortgage crisis is crippling the U.S. economy. What started on Wall Street is permeating Main Street. Local and regional banks that serve local communities are now starting to feel the impact. Consumers have maxed out their equity lines and these loans are starting to default with no chance of refinancing. In addition, most of the borrowing on the commercial side is from small to mid-size businesses. These loans and other consumer adjustable rate loans are viewed by some experts as the next wave of loans to default. The flood of defaults will begin when hundreds of thousands of borrowers who took out so called option adjustable rate mortgages (ARMs) begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, and only a fraction have come due.

Not Just Inflation, Global Inflation

In our last newsletter, we addressed inflation concerns as being over blown. Our view has since changed given the accelerated increase in energy and food prices. It is not the change that is alarming, but rather the rate of that change.

Inflation is not moderating as the economy slows. Inflation is not just an American phenomenon. In fact, rising food prices around the world have led to uprisings in some nations as well as the rationing of basic food staples, such as rice. If this continues, economic growth in these fast emerging countries could slow and, in turn, stifle U.S. growth. These supply shocks underline just how interconnected and dependent we are on our global neighbors.

Food Inflation

Globally, we have under invested in agriculture. We have traded in farms for houses and asphalt. We have neglected our levee systems and have made the family farm a rare entity. Add to this, a diminished commodity supply given flooded farm lands of the Midwest and you have the recipe for inflation. Globally, we are in a perfect storm for a scarcity in commodities. The growing global middle class has an appetite for a western diet and that requires more and more resources for production. In addition, changing weather patterns are taking their toll on crop growth and yields.

To further complicate matters, the U.S. farming industry has been diverted to growing corn for mandated bio-fuel programs. A total of 36 million acres are in the government’s conservation reserve program. As a result, the government pays farmers not to grow crops. Transportation costs play a big role, too. Food is transported from where it is grown to where it is consumed. The distance has grown dramatically over the last few years. Food production and delivery must change in order to sustain billions of people globally. With all of this in mind, we are looking at the supply bottlenecks as sources of potential investment. Water is still the most constrained resource. Weather patterns have made it tougher to sustain large pools of clean and potable water. Higher prices will solve the demand side of the equation for commodity price acceleration, but supply constraints will keep prices higher.

Investment Strategy

Many pundits on Wall Street attempt to identify the market top or its sectors’ bottom. However, this game is inconsequential to investing money or reducing portfolio risk. The investment opportunity stems from identifying what is real and meaningful on a global scale. There are financial realities we think are important in forming our investment framework. Every credit boom is followed by a period in which banks pull back from all forms of lending as they strive to rebuild their balance sheets. This process takes time. The banks are playing defense; executives are looking to make amends for the mismanagement and lack of risk management during the times of easy credit. They are not looking to grow their loan business at the expense of making marginal loans. Credit has long been the life blood of consumers during the recent times of cheap and easy credit. Oil seems to be the commodity everyone is concerned about but there are other more troublesome concerns, like corn and copper for example. Scarcity of natural resources is an issue we need to come to terms with in order to maintain political and economic stability.

We Like this Market

The market is trying to find a bottom. We have seen the market climb higher led by battered financials and home builders. These short covering rallies are false. These upward moves have created extreme volatility which is hard for investors to stomach. On the other hand, we welcome this market volatility. It allows us to properly position our portfolios for the next upswing in the market. We continue to focus on high quality within our favorite market sectors. We believe that industries that embrace innovative technologies will emerge as the new market leaders.

The Positive Side of Oil Prices

What is moving markets towards $150 a barrel for oil and gasoline above $5 a gallon? Are traders manipulating the market? Is OPEC dialing down the supply of global oil reserves? We believe the discussion is really simple. Oil supplies are too light and there are too many production threats around the world. Politically, there are groups looking to push their agenda using oil as the weapon of choice. Furthermore, some of the largest oil reserves in the world are controlled by governments. Every supply disruption has the potential to distort the price of oil.
The answer is not drilling in off shore areas that are currently protected. It is not having Saudi Arabia produce more oil. The oil they are looking to increase production of is the heavy sour crude, not the light sweet crude we consume in the U.S.. Nor is it putting pressure on foreign governments to lift subsidies on fuel prices.

The answer is to change the attitude towards energy production and consumption. This is a reality we need to finally address. We believe this might be one of the most important investment themes that drive our equity strategy. We are accustomed to free markets and access to a vast supply of raw materials. We assume that these materials, like oil, water, gold, and food stuff will always be available in greater supply with better technology. Scientists claim there is a limited supply of most natural resources, and we are finally starting to run against these limits.

In the Long Run

The price of oil and transportation costs between China and the U.S. has tripled over the last few years. Finished goods are being manufactured where they are being sold. For example, Toyota is expanding manufacturing in the U.S. The rising cost of oil is a major disruptive force that will change future industry and could shift population migration. In turn, jobs will be created with tremendous growth opportunities. We are excited about the investment potential these new industries and demographic changes will bring about.

Take Action

With our outlook on the economy and interpretation of global events, there are still sectors with excellent upside potential for the second half of 2008. We believe a focus on quality is critical, given that we are in an environment of continued housing decline and pressure on corporate earnings. As a result, we continue to favor large capitalization, high quality stocks, as well as sectors that focus on growth, rising dividends and stock buy backs. We recommend U.S. industrials and infrastructure that derive a significant portion of their sales overseas. These sectors can benefit from the low dollar and are cost competitive versus their international counterpart. With the earthquake in China and tremendous cash reserves of the emerging markets and OPEC nations, there will be a flood of construction and infrastructure projects. We want to add money to foreign commodity producers (Brazil, Canada and India).

We also want to make a few adjustments to our current holdings. In the recent past, we have been adding the transportation sector and refocusing on utilities. With record oil prices, efficient transportation is crucial and is an early cyclical economic investment. Because of record oil prices, we are taking some profits in our oil position and buying into natural gas. The sector can be bought with the exchange traded fund (ETF) UNG (U.S. natural gas fund). Natural gas companies are drilling more and continuing to add inventory. It is a less expensive and cleaner alternative for the environment than oil. Insider buying of natural gas companies reinforces our conviction. Also, as we’ve been touting for the last few years…buy gold on any market pull back. Traditionally, gold has been used as a hedge against inflation and under owned as an investment. Gold hit its highs adjusted for inflation back in the 80s at $850 an ounce. Our target is $2,400 an ounce adjusted for inflation. Right now it’s at $900 an ounce. We believe it will go higher because production is down in both Africa and Australia.

Bonds-Tax Free Income

Why municipal bonds now? Municipal bonds have high quality ratings even without insurance as well as low default rates relative to corporate bonds. Investors should remember that an insured bond has two layers of credit support, the bond insurer and the underlying issuer (municipality or utility). Why are munis of value? The muni bond sell off was sparked by an uncertain outlook for bond insurers, some of whom suffered losses and credit downgrades due to their exposure to sub prime mortgage securities. The yields on municipal bonds are about 90% of the yield on treasuries. Additionally, for those in high federal and state tax brackets, income could be exempt from federal and or state taxes.

A Debt Free Alternative to Reverse Mortgages

While reverse mortgages have been around for decades, only in the last couple of years have there been alternatives that allow retired people to unlock their equity without tying up their present and future equity in a reverse mortgage.

Now there is an option that allows a property owner (residential, land, investment and commercial) to own and control all their existing equity and obtain immediate cash in exchange for future appreciation. Like a reverse mortgage, there are no monthly payments, but this is where the similarities end. This is a program that can add $1,000 or more a month to your retirement income. It could also assist you in restructuring your debt to lower your monthly payments. This form of equity access can be extremely valuable as an estate and tax planning tool. To learn more, click here.

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 karpcapital.com

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