The Lost Decade

2009 was nothing less than exhausting for most investors. Looking back on the year, there were opportunities available to those who had an investment strategy. Psychologically it was difficult for even the savviest investors. For many, 2010 will be a year for guarding gains and managing risk. Investors will need to focus more on maintaining what they already have. The global economy is still weak and vulnerable to outside shocks like the recent developments in the foreign debt markets. The challenges in 2010 are many. The U.S. economy must grow to create jobs instead of just losing fewer jobs. We need to move from a government created Gross Domestic Product to the private sector creating goods, services and demand. Recent data suggests improvement and there are signals of a recovery on the horizon, but there will be starts and stops. Be prepared. Against this backdrop, we will outline our investment strategy and financial planning agenda for the first quarter of 2010.

Here are the performance numbers for the major indices for 2009 and 2008 for comparison purposes. What a difference a year makes. (% Change without Reinvested Dividends)

A Crisis in Confidence

We have come a long way from the world financial meltdown over a year ago. The Federal Reserve took unprecedented steps to stem the tide of a depression. U.S. central bank officials, led by Federal Reserve Chairman Ben Bernanke, are trying to make sure markets get the message that just because the economy is showing signs of recovery, it doesn’t mean that a big change in the Fed’s monetary policy stance will follow. For some time, central bank officials have been making the case that they would be keeping interest rates right around 0% for an extended period, largely because of a modest recovery and weak labor markets. In their eyes there is little threat of inflation, and no need for tighter monetary policy. We disagree given the flow of economic data signals, upward pressure on commodity prices, and unexpectedly good employment figures for November and December. The Fed has created growth by flooding the economy with dollars. As a result, the dollar has fallen precipitously and paying down the accumulated debt with cheap dollars will be a monumental task. In addition, the Fed has interfered with the workings of the markets. By propping up numerous sectors of the economy, (including banking, insurance and domestic autos) it has gone beyond the role of controlling the money supply. What will the end result be? How will the government withdraw the excess stimulus while not throwing the economy back into recession? This balancing act has never been successfully orchestrated by the Federal Reserve. The question is, will the government-induced economic growth morph into private sector spending? We believe the consumer has undergone a structural shift from spending to paying down debt and saving. If growth is to come from the private sector, then it is important for the government to create an environment in which entrepreneurs and businesses are willing to take risks and invest capital. This environment requires less government regulation and lower taxes, not more. Given our current fiscal and monetary predicament, it feels as though we are on the wrong track.

The Global Debt Crisis - Why We Care

One of the most misunderstood global macro risks in the market today is that of sovereign debt defaults. Many market pundits are brushing off what is happening in the debt markets of the Middle East, Spain, Ireland and Eastern Europe as isolated events. This mindset is very risky. Sovereign defaults, as a percentage of total global defaults, remains at a generationally low level. That can change. The lesson from the financial crisis of 2008 suggests that Dubai World is probably not the only entity that binged on debt to buy overpriced, rapidly depreciating assets. This doom and gloom scenario could just be another global central bank coordinated rescue program with more to follow. We are now seeing the U.S. Dollar Index starting to rally. Is the rise in the dollar because of a flight to safety or improving economic conditions? The rally in the dollar was unexpected given that gold reached a recent high during the same week as the announcement of the Dubai fiscal crisis. Furthermore Middle Eastern debt defaults, combined with a breakdown in the price of oil and commodities in the near term, are some of the main reasons we want to be cautious about continuing to hold foreign debt to create income. Because of this outlook on the markets we are reducing or eliminating our holding in the ETF Sovereign Debt Fund. Sovereign debt has been a good source of yield for the last year but at this point we believe the risk has begun to outweigh the potential for further reward. Until we know if the rally in the dollar is sustainable, we’re going to take a more prudent approach by controlling risk and preserving our client’s existing capital. There are more compelling income alternatives available.

As the Market Goes, So Goes the Economy

What are the prospects for the equity and bond markets in 2010? The question we are asked most frequently is what’s the sustainability of the current rally off the March lows? We have certainly come a long way very quickly and the expectation of most investors is that a correction is coming. We are seeing corrections coming in waves. At the end of the year we saw gold, commodities, and the financial sector correct swiftly while technology, healthcare and utilities led the market. We don’t expect a broad based sell off in 2010. The level of cash is still very high and the pressure of putting money back to work is growing. As the U.S. economy continues to improve, we believe the money on the sidelines will slowly find its way back into the equity market providing the fuel for further gains.

Economic recovery seems to be a favorite story among the media, with bad news being pushed to the back pages. If economic news flow continues to remain positive, the economy has a chance to post GDP growth approaching 4% for 2010. Keep in mind, we still think there are headwinds to sustainable growth. The markets are focused on recovery. The bulk of the stimulus monies will not hit the economy until the end of the first quarter of this year. If you are a client of Karp Capital and/or have been reading our newsletter you know that we have been hedging the accounts for the last year. We haven’t taken off the hedge yet, but have not been adding to it recently. Our forecast must take into account the reality that minimizing portfolio risk is at least as critical as maximizing returns. It is important to take on risk if there is more than an equal opportunity of gain or income. We are cautiously optimistic in the near term but we cannot rely indefinitely on government spending as the primary growth stimulus without causing irreparable damage to our economy and our standing in the world.

Wall Street vs Main Street

In the last installment of Karp Capital Focus, we touched upon Wall Street paying out tremendous bonuses. The Wall Street versus Main Street issue runs much deeper with the growing divergence between large companies with easy access to capital market financing and smaller companies that face difficulty in obtaining loans. Main Street is, in effect, lending and subsidizing Wall Street given the zero interest rate policy of the Federal Reserve. In finance land, this is called the yield spread. This is the difference between 10 year and 2 year U.S. Treasury yields. This is also the difference between what American savers earn on their fixed income investments and what the bankers earn when lending monies. The Federal Reserve has created an environment that only Wall Street can survive. Banks still need to tend to their own health, particularly with respect to the lingering losses from distressed real estate remaining on their books. Projected real estate loan losses still to come are massive. The bulk of option ARM reset dates are on the horizon in 2010 and 2011. (click here) It’s also important to remember the potential commercial real estate losses have not fully been quantified. The reality is that these loans were never meant to survive the reset. Unless credit conditions improve for consumers and small businesses, the situation is a ticking time bomb. We were very early in predicting the real estate debacle and some clients thought we had over-estimated its severity. In hindsight, we were correct in our prediction but partly wrong in how to capitalize on the opportunity. The public markets allowed Real Estate Investment Trusts and some mortgage firms to raise capital, others were bailed out. Because of this, our hedge against the commercial real estate market was diffused. Given our negative outlook for the commercial real estate market and loan losses, our investment allocation could still mitigate the long term volatility of account performance. Still we remain prudent in our risk management with an eye on the growth portion of long term investments. The administration needs to support small to mid size businesses directly. Small businesses employ the majority of workers in the United States. Even after President Obama’s meeting with large money center and community banks, monies are not being lent to small and mid size companies to fuel economic growth. This is a very complex relationship which is hurting the nation’s prospects for future growth.

Deflation vs Inflation

Given the recent economic data, we believe deflation is off the table for the time being. Underlying inflationary pressures have begun to simmer. So far, we have not seen a surge in inflation. When you look at measures like the CPI, inflation looks to be negative. Our issue with the CPI numbers is the way in which they are calculated. The CPI uses the end numbers and does not take into consideration the components that make up a finished product or the inputs required to deliver a service. Based on this data, you could say that we are currently in the eye of the storm. Inflation pressures tend to build slowly and accelerate to the upside quickly. The Federal Reserve faces a tremendous dilemma and could be part of the problem if it doesn’t raise rates to stem inflation. Its current policy position has greatly increased the risk of a surge in inflation. We are confused by the Fed’s actions and statements. The last thing we want is to be behind the inflation curve. The days of Paul Volcker and 18% plus interest rates is a distant but very painful memory. The near term reading is that we are in the midst of an economic recovery. We believe we have turned the corner and will invest in sectors that tend to perform well in an inflationary environment. Companies that succeed during inflationary times are those that can effectively manage their input costs and pass on price increases to consumers. Pricing power is a key focus in our investment thesis. Given the tenuous nature of the recovery, we hold our market hedges.

A Whole Lot of Nothing

The decade that just ended is the worst in the history of the U.S. stock market—worse than all of the many boom-and-bust cycles of the 19th century, worse than the 1930s great depression and worse than the recession plagued 1970s. The S&P 500 opened the decade at 1,469.25 on January 3, 2000. When the market closed on December 31, 2009 the S&P 500 stood at 1,136.52 the index’s annual performance over that span is negative 2.26 percent. The Dow Jones Industrial Average has lost about 1 percent per year over the same period, and the NASDAQ Composite is down a whopping 5.9 percent annually. When adjusted for inflation, the 10-year returns for these indices are even lower. On the other hand, gold and commodities had an annualized rate of return over the decade of over 13%. This was driven mostly by rapid economic growth in Asia and elsewhere in the developing world.

So What are We Buying?

In the U.S. we are focused on the new defensive investments such as technology, healthcare and utilities. The utilities sector has lagged the current market rally yet pays a healthy dividend in comparison to other dividend-paying sectors and government bonds. Overseas, we still like Brazil. Important steps taken since the 1990s toward fiscal sustainability, as well as measures taken to liberalize and open the economy, have significantly boosted the country's competitiveness, providing a better environment for private-sector development. Also worth noting, Brazil has avoided cutting interest rates. At this time, we are concerned with our exposure in the Asian markets; specifically in China. We anticipate a slowdown from an economic data perspective vs expectations beginning in the second quarter of 2010. China has implemented a massive stimulus program, fueling high growth and low inflation. We believe the official statistics overstate the true economic growth. We are seeing inconsistencies in overall growth vs the various sector sales data. For example, while the growth in car sales is massive, there is no commensurate increase in gasoline sales. Another example: the real estate market is starting to correct and excess manufacturing capacity has been created in many industries. We would rather sell while the Chinese market is still relatively strong and trim back our exposure before it’s realized in the market.

What about Bonds?

Long term bonds are starting to sell off as the Federal Reserve tries to hold down short term rates. Investors are betting the U.S. recovery will fuel inflation and reduce demand for government debt sales. Also noteworthy is the difference between yields on Treasury Inflation Protected Securities (TIPS). Similar government notes climbed to 2.36 percent, the most since July 2008. Investors, however, are getting nervous with the belief inflation is just around the corner. The scarcity of yield has created tremendous interest in high yield bonds. The high yield bond sector staged an impressive comeback last year with returns of more than 52%. Cash rich investors searching for income have driven up prices on these risky bonds. We are taking profits and believe there are other opportunities for income.

Our bond strategy for 2010 has little to do with bonds. Given our outlook for higher rates except on the long term bonds, we choose high dividend yielding stocks, while scaling back fixed income holdings. This means buying utility and telecom sectors, as well as master limited partnerships focused on the transportation of natural gas and oil-related products. (click here for more information) Other alternatives to traditional bonds include bank preferred stock and convertible securities. These investments have the potential for capital gains and rising income to offset inflation. Additionally, income from most of these investments benefit from favorable tax treatment. We have been adding these investment sectors to our portfolios over the last six months to increase income and reduce portfolio volatility as the markets anticipate rising interest rates.

Even as the stock markets have rallied since March, the low yields have not discouraged investors from pouring money into bonds and bond mutual funds. When (not if) interest rates climb, any yield earned will be eaten away with bond principal losses. The treasury and mortgage markets look particularly vulnerable because of support by the Federal Reserve in its efforts to keep short term rates near zero and its purchases of these securities. If you would like to review how we are adjusting the investment allocation in your portfolio, or have additional income needs, give us a call.

Take Action

Everyone in the financial planning world is talking about the merits of the Roth IRA conversion opportunity for 2010. You might want to think twice before converting your IRA, SEP or IRA rollover. As of January 1, 2010, there’s no income limit on who may exercise the Roth conversion. While there are good reasons to consider a Roth, tax-free growth and favorable inheritance rules, we recommend a thorough analysis beforehand. Assumptions about the future can make the Roth conversion look attractive when in reality that might not be the case. You could be paying taxes now based on the uncertainty of tax rates in the future. Paying taxes now is contrary to all financial planning strategies. If you are going to proceed with the conversion, be sure to have the cash available to pay the tax bill. If you do convert to a Roth IRA in 2010, you can choose to pay half the taxes in 2010 and half in 2011. Opting to convert in 2010 may make more sense for higher income taxpayers because of the likelihood of a tax increase in 2011. Call us to see if converting to a Roth is the right option for you and your family. Click here for more Roth Information.

Next Steps

Start 2010 by taking an inventory of your finances. This includes all your assets and liabilities. All of your year end 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 portfolio’s 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.