The Times They Are a Changing

The rally in the markets gave investors a chance to catch their breath and enjoy the end of summer. Now the question on everyone’s mind is whether equities have gone too far, too soon. Since the March 9th low, the S&P 500 Index surged more than 63% through September 30th. However, this remains below levels prior to the banking crisis a year ago. Solid evidence backs up these gains as corporate earnings beat lowered expectations, productivity continues to increase, and housing data shows signs of stabilizing. Nonetheless, legitimate concerns linger as consumer spending remains weak, inflation expectations are rising, and the federal budget deficit is ballooning. Many investors are realizing that their money is going nowhere sitting in money markets and short term government bonds (with 0.25% short-term interest rates.) They are coming to the conclusion it’s better to re-enter the market now than wait for a large correction that may not materialize. In this installment of Karp Capital Focus we will discuss what has changed in the markets, the economy and the financial service industry. Despite what the financial pundits are saying, we would rather listen to what the markets are telling us. We’re optimistic further market gains are in the future, but remain prudent when putting our cash position to work.

Here are the performance numbers for the major indices.

A Lesson Learned

After avoiding a catastrophe last fall, the financial system has recovered dramatically, aided in no small measure by the aggressive action of the Federal Reserve, the Treasury and the policy makers in Washington. The cost of credit has fallen, liquidity and risk are coming back into the markets, banks are poised for profitability and equity markets have rebounded. There is no doubt that more prudent lending and borrowing is necessary and might actually result in more sustainable growth in the future. With all that has occurred over the last year and on the anniversary of the collapse of Lehman Brothers, here is what we have learned:

• The regulators were not enforcing the rules
• The world financial community is more interconnected than previously thought
• Many investors discovered that they’re less comfortable with risk and volatility in their portfolios than they had believed
• It’s necessary to rethink our retirement plans

Keep in mind before the collapse of Lehman Brothers we were in the midst of a recession. In the last six months we have come back from the edge of the financial abyss. The question is, will Wall Street, governments and consumers make changes so we can have a stronger economy moving forward? We are not so certain. We hoped the government would use the Madoff case and others to enact true regulatory reform. The key is not to lose the momentum of the events over the last year. We fear that Wall Street has not learned its lesson. Goldman Sachs just announced that the average bonus per employee was over $700k. Given the taxpayer’s support of the industry and the turmoil experienced by Main Street as a result of Wall Street’s irresponsibility, these executive payouts were obscene. Our banking system has not emerged any better off, either. In fact, it is more divided under TARP and the financial crisis. The large money center banks are getting bigger and more influential. Wells Fargo bought Wachovia; Bank of America acquired Merrill Lynch and JP Morgan Chase took over Washington Mutual. The large banks have reinforced the “too big to fail” argument. A positive outcome from the past year is the consumer is saving more and paying down debt. Has the consumer changed? We think in many respects, yes. Throughout the crisis and recession, labor productivity has held up well. Clearly, the U.S. economy has dug itself a pretty big hole; the good news is that it seems to have stopped digging.

Lower Lows for the Dollar

Even in the wake of an improving economy, the dollar continues to dip. We expect the dollar to bottom as soon as the Federal Reserve addresses the dollar’s decline. In the Federal Reserves’ minutes from the September meeting there was no mention of the decline of the dollar. This was amazing to us. The market is telling us something and we have to listen. Are investors worried about inflation, run away spending in Washington and trade wars with China? We think this is true. Is the weak dollar good for the U.S. economy and stocks? That’s easy. A weaker dollar is good for corporate earnings. It tends to boost U.S. exports. It also increases the dollar value of profits earned abroad by American companies. So why are so many investors so worried that a falling dollar is bad news? Historically, a weak dollar is a result of a faltering economy and accommodative monetary policy. A weak dollar boosts the cost of our imported goods. However, the real cost of goods (with inflation taken into account) remains subdued in the U.S. Could it be that a weak dollar is a lagging indicator for the health of the economy? Could it be we are seeing re-inflation of the stock market (from the flood of stimulus monies?) This is a question that we have been pondering. It could be that the rate of change in the dollar is more important than the absolute value. Keep in mind a slow decline in the dollar gives world markets time to adjust.

Bad News Persists

In Mid-September we learned that the August unemployment rate rose in 27 states. California and Nevada each hit record high rates of 12.2% and 13.2%, respectively. Payrolls declined in 42 states and the District of Columbia, even though the U.S. economy had already lost 6.9 million jobs since December 2007. Unfortunately, job losses will likely continue. In the financial sector, 92 banks have failed so far this year. Hundreds more are expected to fail in the coming year largely due to outstanding loans for commercial real estate. The FDIC’s funds to back accounts in failed banks have fallen to 0.22% of insured deposits – well below the congressionally-mandated minimum of 1.15%. In fact, the $10.4 billion in the FDIC fund as of June 30, 2009 was down more than 75% from the $45.2 billion as of June 30, 2008. The FDIC estimates that by 2013 bank failures will likely cost it $70 billion. This is grim news but not unexpected given the over capacity in the banking industry.

Trade Wars

Trade troubles brewing with China is another area of concern for investors. For the first time in history, a president has directly imposed a tariff. Of course there is always political posturing, but this is not a road we want to travel as a nation. Diplomacy is needed to soften our stated position. Not long ago, the U.S. slapped a 35% tariff on tires made in China. The Chinese might retaliate by taxing imports of U.S. auto parts and poultry into China. In response, China is reviewing U.S. subsidy polices and may also file a complaint with the World Trade Organization. It’s important to remember China is the second largest U.S. trading partner after Canada. The potential exists for an unanticipated escalation of protectionist policies. Since one of every five tires in the U.S. is made in China, unions lobbied for the move to protect jobs. President Obama is a supporter of free trade but said this move is to enforce trade agreements that are not being upheld. Tariffs tend to raise costs and cause job losses long term. (Click here to see the past market affect of high tariffs and protectionism) If this type of banter escalates it could open the door for tariffs on consumer goods, steel and electronics. In addition, the Chinese are the largest holder of U.S. debt. China's Central Bank Governor, Zhou Xiaochuan, reminded the world of China's economic priority. When it comes to monetary policy he called "currency stability the most important factor.” With this in mind, the U.S. needs to take steps to stabilize the dollar.

Real Estate - What to do Now

Housing has been at the epicenter of the financial and economic crisis. Over the last few months the numbers of home starts, foreclosures, prices and sales have been trending better than expected. Even though the free fall seems to be behind us, certain home price levels are fairing better than others. Year over year, the sub $250k price range is seeing positive price appreciation while the higher end of the market is off as much as 22-30%. Either way, falling home prices have weighed heavily on household wealth and will have an effect on the future of the economy for years to come. In our opinion, there is another ticking time bomb. Over the last couple of years the focus has been on sub-prime loans defaulting. These defaults have been slowing down and prime loans have taken center stage. There are many interest only prime mortgages that will be resetting in the next few years. These are loans that require borrowers to pay only interest at first and put off paying principal for several years. Most of these loans were fixed for 1, 3, 5 or 10 years. (Click here to see reset rates) Now, with many homes worth less than the loans against them, many interest only loans are a dead end for borrowers. In fact, 1 in 4 Americans has negative equity in their home. In addition the unemployment rate is moving higher. It comes as no surprise that lenders are tightening their underwriting guidelines. Most lenders are requesting that the borrowers have substantial borrower equity in the property. The banking community insists that borrowers have a job and qualify for the loan. The liar loans, and no income, no documents loans are a thing of the past. Borrowers have no choice other than to start paying principal with their interest payment. This could mean a new wave of foreclosures in the near future. In this housing climate we believe now is the time to buy investment real estate at the entry level, even though the home buyer tax credit hasn’t been renewed. Investor buying is subsiding and new buyers are apprehensive given the continued slide in overall home prices. We might be a little early, but our investment time horizon is 7 to 10 years. If you would like to review how investment property could fit into your financial plan please give us a call.

Bonds are Getting Attention

Most investors know bonds have out performed stocks over the last 10 years. Sector performance varies according to the economy’s current business cycle. Over the last 6 months we have recommended investing in high quality and high yield corporate debt. These two sectors have out performed the stock market during that period. Historically, municipals have done well mid to late recession, however, we are still concerned with the budgetary problems of most states. We would recommend reducing exposure to certain municipal bonds in favor of stocks that pay dividends and foreign bonds. These bonds have performed nicely this year. We attribute some of the performance to the weak dollar and cuts in the Fed Funds rate. We are seeing corporate spreads, the difference between the yields offered on corporate versus treasury debt of the same maturity, narrowing to levels unseen since before the collapse of Lehman Brothers. Prices, which move opposite to yields, have jumped. How much further can prices go? If corporate profits shrink, bonds could experience higher default rates. Inflation is a bond’s worst enemy because interest payments are fixed. We look at the other side of the coin. Coming out of recession, to the extent we experience increased inflationary pressures, stocks may out perform bonds as companies pass along higher costs of production to consumers in the form of higher prices. As the economy exits recession, inflationary pressure may emerge due to the trillions of dollars of fiscal and monetary stimulus created by our government. The last time spreads in investment grade bonds stood at current levels, stocks were 26% higher. Because of this, we are moving monies from bonds to stocks.

Rebuilding Your Nest Egg - Our Game Plan

Research shows that the pain of financial loss is much more acute than the satisfaction of a gain. Investors are often tempted to take too much risk to compensate for losses. This should be avoided. Instead, you can reach your financial goals through a careful strategy of investment, savings and retirement planning. We are seeing plenty of investors that believe buy and hold will work and traditional allocation and rebalancing is the road to financial security. The new reality for investors and money managers should be evaluating and reducing risk in portfolios. True diversification can improve returns and reduce risk. We define risk by loss of principal. Market risk changes over time. Investors also need to change their thought process on investing. This is long overdue. In order to help our clients reach their financial goals, they have to understand the changes in the financial industry and the markets. Over the last year we have seen a few of the large investment houses on Wall Street fail. Their brokers feel pressure because, as football great Peyton Manning said, “Pressure is something you feel when you don’t know what the hell you’re doing.”

What are We Buying and Why?

We continue to expect value to outperform growth for the remainder of the year. Our enthusiasm for equities is lower in the near term than it was a month ago. Given current levels of Wall Street optimism, it may pay to be a little contrary. We use investor sentiment numbers and market indicators to gauge how and when to apply hedges to our clients’ portfolios. Market valuations are above average but not excessive. Individual investors remain pessimistic and the Fed continues to inject monies into the economy. We believe that risk has increased, and gains in the near term will be harder to achieve than in the past 6 months. The trend is hard to ignore yet there are signs that the dollar has started to stabilize. This is important as it influences our investment strategy.

We control risk by a process called diversification and investment weighting. Allocation decisions are determined by the extent to which that security or sector adds uniqueness and helps balance the portfolio. Each investment in the portfolio fits together. We are constantly looking for opportunities to realign portfolios to give our clients the best trade off between risk and return. Rotation of various asset classes, sectors and industries has been the core of our investment strategy in response to business cycles. With the worst of the economic downturn behind us, but an economic recovery still beyond reach, we are emphasizing high quality for our fixed income and equity investments. We believe a focus on quality is critical given the potential pressure on corporate earnings in the face of higher borrowing costs. Non-dividend paying stocks have out performed dividend paying stocks over the last year. The rally from March 9th has been lead by lower quality securities. We believe this will change given the shortage of investment income. Our focus continues to be on groups that derive a large portion of sales from outside the U.S. We want to take advantage of the currency impact on earnings given the falling dollar. Large cap technology and energy derive more than half their sales overseas. We continue to add natural resource exposure to the portfolios. This sector should benefit over time given the continued industrialization of China, India and the emerging markets. It’s our belief that overseas stock markets will continue to out perform the U.S. This long term trend is in place given the growing middle class in emerging economies and the weak dollar. We want to own the indices of the BRIC countries (Brazil, India and China, excluding Russia.) Our long term strategy is to continue to add stocks over bonds. Our base allocation is 60% equities, 35% bonds and 5% cash.

Want a Program to Jump Start your Retirement Plan?

Over the last year, good news has been scarce. There was a gift that has received little mention. Thanks to a provision in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, the $100,000 income restriction on Roth IRA conversion eligibility is set to be lifted as of January 1, 2010. So what does this mean to you? The change will offer investors a true advantage in the quest to re-build and retain retirement capital. The conversion from an IRA to a Roth IRA creates a strategy whereby you accelerate paying taxes on retirement plan assets with the opportunity of building greater wealth in the future. After the conversion, the monies in the Roth grow tax free! Additionally, there is a special tax incentive for those who choose to convert during 2010. Conversions done next year will allow the taxpayer to delay taxes. The Roth IRA is not new; it has been around since 1998. Previously the Roth conversion was available only to households with $100,000 or less of modified adjusted gross income. Now Roth conversion is available to everyone instead of those who would least likely be in a financial position to take advantage of it. This is a potentially invaluable planning tool. It is essential to weigh key variables to evaluate the pros and cons of a full or partial Roth IRA conversion. Call us to review your options. (To find out more about the Roth Conversion click here)

Estate & Gift Tax Planning in Challenging Times

Believe it or not, there is a bright side to these dark economic days. Because of the decline in asset values and historically low interest rates, it is possible to make wealth transfers today and save substantial taxes for your family. It is worthwhile to consider making gifts, loans and transfers of interests in businesses to family members, especially if you believe your assets will grow over time and you are concerned about reducing your potential estate tax liability. Another reason for acting now is that various estate planning tools used in the past to reduce taxes are likely to be under attack in the next year or so. Call us for a copy of the article Estate and Gift Tax Planning in Challenging Times by Jan Fox, attorney with Hoge Fenton Jones & Appel.

Next Steps

Start by taking an inventory of your finances. This includes all your assets and liabilities. Since it’s the end of the quarter, all your bank, credit, investment and retirement statements will be delivered in the next two weeks. We view today’s environment as an opportunity to upgrade your investments, recalculate your income streams and determine your true risk tolerance. These are times that test your commitment to your goals. It has been proven over the last two years that a standard buy and hold portfolio is not the strategy to use as your goals change and the fundamentals of the financial markets evolve. There are ways to transfer and reduce risk that are fairly new concepts to most investors. As you approach retirement or rely on your portfolio for income replacement, it is prudent to look not only at portfolio diversification (stocks, bonds, commodities, currencies and real estate) but also investment product diversification. Don't hide -- take an interest…. It is your money. Call us to review your portfolio or to address your financial concerns.

At Karp Capital we’re here to listen to the concerns of our clients, give sound advice, and execute their financial plan. 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’re 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 portfolio¹s performance, please call me at 877 900 Karp. Working with Karp Capital, there is only one boss, YOU!

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

If you no longer wish to receive the Karp Capital Management Focus newsletter, please contact us to be removed from our mailing list . 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.