2nd
Quarter Report
|
Written by Peter Karp |
July, 2010 |
The market tried to sustain devastating news throughout the quarter, but to no avail. The Dow broke below the psychological 10,000 level at the end of the quarter. The S&P 500 found itself in a similar condition, closing at a new low for the year and the past eight months. Some of our deepest fears have been realized from the worst environmental disaster in modern times. We also saw the collapse of the euro and insolvency of sovereign governments. Market participants abandoned risky assets and looked for safety, which included treasuries with rather low yields. Interest rates for 10 Year Treasury Notes closed at 2.94 percent, the first time it has ventured below 3 percent since April 2009 – at the early stage of the economic recovery. Investors have forgotten the concerns they had about the growing size of the U.S. debt and instead have rushed into treasuries as the equity markets have fallen. The second half of 2010 will likely be characterized by continuing the flight to quality trend. The Fed’s GDP forecast points to a growing economy, yet the latest data made many of us wonder what will perpetuate growth. When will companies start spending cash? When will they aggressively hire workers? When will credit finally loosen up? What is on the horizon? The excitement about political change in November during the mid-term elections should help boost investor optimism. Due to a weaker U.S. dollar, low interest rates and falling commodity prices, deflation talk is starting to emerge. While U.S. prices drop, the fast-growing BRIC (Brazil, Russia, India, China) nations are fighting inflation. The market seems to be waiting for more meaningful direction from catalysts such as mid-July corporate earnings and investor’s interpretation of the June employment data. The lingering uncertainty surrounding some of the more onerous provisions in the financial reform legislation remain an overhang on market sentiment. When combined with concerns about a double dip in home prices, investors find another excuse to shun stocks. It will be a long, hot summer for investors.
In This Issue: U.S. vs The World - G20 Summit The Housing Recovery that Never Was Risk vs Volatility – Who Cares? Health = Head, Heart and... ART _________________
|
Here are the performance numbers for the major indices (total returns as of 6/30/2010):
June 2010 |
Latest 3 Months |
Latest 6 Months |
Latest 12 Months |
6/30/10 Index Close |
|
| Dow Jones Industrials | -3.42% |
-9.34% |
-4.98% |
18.93% |
9,774.02 |
| Standard & Poor’s 500 | -5.24% |
-11.43% |
-6.60% |
14.43% |
1,030.71 |
| NASDAQ Composite | -6.55% |
-12.04% |
-7.05% |
14.94% |
2.109.24 |
| Russell 2000 | -7.88% |
-10.19% |
-2.54% |
19.91% |
609.49 |
| MSCI EAFE | -1.16% |
-14.91% |
-14.72% |
3.13% |
1,348.11 |
| Long Term Treasury Bonds | 5.07% |
13.47% |
14.26% |
12.08% |
|
| High Grade Corporate Bonds | 5.04% |
8.39% |
10.37% |
20.03% |
|
| Gold | 3.02% |
11.52% |
14.39% |
33.12% |
|
In June, defensive sectors with above average dividend yields outperformed cyclical sectors. Treasuries led +5.1%
and equities lagged -5.2%. All sectors of the S&P 500 were in negative territory for the first half of the year. The best
performing equity strategy for the last 6 months was Dividend Yield. Mid Cap Value has been the #1 performing
investment style for the last four quarters. |
|||||
The pundits focused on the ugly nature of the jobs report. Yes, the headline number was dismal but if you dig deeper, there was a bright spot in the release. During May, the average work week and hourly earnings increased. This suggests that demand for employers’ products and services are on the rise. Companies are employing more labor in terms of hours as well as increasing workers' compensation. This is consistent with an expanding economy and bodes well for future job gains. As of the end of the quarter, layoff announcements in the U.S. are slowing and trying to stabilize. Corporate cash is another bright spot for the economy. It recently hit an all time high. This suggests that the pace of both job creation and capital spending could increase at a faster clip in the near term. This means companies could start hiring.
U.S. vs The World - G20 Summit
The U.S. pressed its economic partners to cautiously tighten their fiscal policies while the global economic recovery remains uncertain. Worried the world economy could slip into recession as it did in the 1930s, President Obama urged his counterparts at the G20 to sustain economic growth through some level of stimulative spending. At some point, however, bond investors will ask for higher interest rates which could then begin an upward climb. This was part of the problem in Greece. It was a mistake that other countries can learn from. By not dealing with our deficit, we’re laying the groundwork for a future crisis even worse than the one we just had. But cutting the deficit too quickly could also throw the country back into a recession. There needs to be a balance. Politicians around the world are starting to embrace a new found desire for fiscal austerity. The measures proposed are often aggressive cost cutting or tax increases that threaten the near term economic recovery. European leaders are more cautious about spending, chastened by the example of Greece. In Greece, investor confidence was shattered by mounting debt and the possibility of a default.
Keep in mind, if a country cannot print its own currency (such as Greece or Ireland) the only way it can return to competitiveness is by decreasing the cost of production. And that’s not just goods but also labor costs. The catch is, if you reduce labor costs, you receive less tax receipts. Those calling for countries to quickly cut their deficits are telling them they must enter into a temporary recession to get the European Central Bank to buy their bonds to support government spending. What choice do they have? If they do not make the spending cuts, the bond market may dry up and their interest rates will skyrocket. This, in turn, will force more severe cuts.
The United States continues to rack up debt. With the U.S deficit estimated at $1.6 TRILLION for 2010 (+14% vs ‘09) Peter Orszag, Obama's budget director, has decided to leave the Cabinet. Who could blame him? CLICK HERE FOR THE DEBT CLOCK http://www.usdebtclock.org. Meanwhile, U.S. businesses have been practicing financial austerity for over two years now, setting an example for our government. The U.S. has always benefited from its reserve currency status. This allowed it to accumulate trade and budget deficits for an unusually long period without immediate repercussions of inflation or higher borrowing costs. This false sense of security, however, may backfire in the future.
In June, China announced it would relax its currency peg to the dollar. The best way to control inflation on the home front is a strong currency, a move taken directly from the playbook of Ronald Reagan and Paul Volcker. Economists say a higher yuan could help temper inflation in China by driving down import prices. China was also under pressure from the U.S. and others to allow the yuan to rise in value. The artificially low price of the yuan was seen as an increasingly unfair trade advantage for Chinese exports. Changing its currency policy, China has taken the immediate political risk of a trade war off the table. That’s good for the markets. Chinese consumers have a growing appetite for a comfortable life style. They get more for their money because the yuan is worth more versus other currencies. This is good news for growing the Chinese economy and solidifying China’s position as a global financial leader. This could push U.S. multinational companies higher and reignite commodity prices. On the flip side, anything made in China will cost more for the U.S. consumer. The U.S. will import fewer Chinese goods and will exchange fewer dollars into yuan to pay for them. This means the Chinese government will receive less U.S. dollars and they’ll have less to invest in U.S. treasuries. Our record size U.S. China trade and investment imbalance will gradually correct. Greater flexibility of China’s exchange rate is necessary for the continued health of the global economy. |
In our opinion, gross domestic product (GDP) will stabilize at the current level. There is still $380 Billion in unspent stimulus money. Nearly half the remaining money is earmarked for infrastructure projects. Growth in the 3rd and 4th quarter will stabilize given business’ need to rebuild inventories. More businesses are spending monies on equipment and software. Large companies are flush with cash from cutting costs and raising capital in a low interest rate environment. The banks are still not increasing loan activity, which is a drag on growth. Loan repayments are running at a faster rate than new loans are being granted. Bank deposits are also rising at a healthy clip. In order to support future growth there has to be net bank lending. But what will it take to get banks to start lending again? It seems to be a Catch-22. Banks aren’t lending nearly enough. Companies are having trouble growing because they can’t get the loans they need, thereby prolonging high unemployment. Just keeping rates down is not sufficient in our view to stimulate bank lending. More government spending to create jobs is not a reasonable alternative. The solution could simply be the Fed raising short term interest rates. Banks fear financial reform will require more cash on the balance sheet as they are required to value defunct loans and assets at market prices, slowing, not contracting the economy. The end of the year is our concern. We do not see the economy expanding enough through demand to push down unemployment. In turn, this will keep Bernanke and the Federal Reserve from raising rates. What they should do and what they will do are probably very different things. |
We sold our dollar position in the middle of June. Instead of implementing austerity cuts similar to those used by members of the European Community, American politicians continue to spend. President Obama will continue to try to convince Congress to approve a supplemental spending bill for extending unemployment benefits. With all the talk about the dollar being King, the dollar is not even King of North America. The dollar has fallen against its nearest neighbors, the Canadian dollar and Mexican peso. Recently, the dollar resumed its long term drop versus the euro, despite the widely publicized euro debt crisis. Which investments protect from a drop in the value of a currency? Historically, gold, corporate bonds and income earning real estate have been the best hedges against currency debasement. We have been adding to our gold and real estate positions on market pull backs through exchange traded funds. During the Great Depression of the 1930s, a decade where prices fell at an average annual rate of 2.1%, the winning investment was high grade corporate bonds. They achieved an annual return of almost 7% while long term and intermediate term U.S. government bonds had annual returns of 4.9% and 4.6%. On the domestic front, the stock market embraces a weaker U.S. dollar. A weak dollar helps boost earnings of multinational companies that derive earnings overseas. In addition, we are buying the country funds of Canada, Australia and India. The economic growth in Brazil, China and India will continue to boost global growth, despite Europe's malaise. |
The Housing Recovery that Never Was
May is usually a strong month for housing but the housing numbers were weak. We have started to see data that reflect a slowing of the domestic housing market. Expiration of the home buyer tax credit pulled demand forward and now the market is suffering without that support. May new home sales collapsed coming in at 300K, down 40% month over month. This was the worst new home sales number since 1963, when record keeping began. Keep in mind that mortgage rates remain near all time lows while affordability remains high. Why is there such a disconnect? One major driver is the employment environment. Without a job or substantial job history, it’s difficult to qualify for a mortgage. In June mortgage applications were down substantially. Since mortgage applications are leading indicators for housing purchases, the forecast for the summer selling season doesn’t look very bright. Supply is also an issue given there are almost 6 million additional homes that can be added to the market. As negative equity increases, so does the propensity to default. As a result, greater home inventory is created. Almost 4.9 million people are underwater by more than 25%. Given the massive drop in mortgage applications since the first time home buyer credit expired we see no chance of a quick sustained recovery in housing. Click here for the shadow inventory of homes.
Risk vs Volatility - Who Cares?
It may seem like the distinction between risk and volatility is purely semantics. In many cases, you hear these two terms used interchangeably in the investment arena. It can be helpful to draw a distinction between the two terms and be clear about how they relate to each other. There are many types of risk: portfolio, time horizon, liquidity, credit, political, etc. The two most relevant risks for this discussion are 1) asset risk of a specific investment for a specified time and 2) the risk of achieving or not achieving the desired growth and value of your assets.
Asset risk is often called volatility because it’s measured as the amount of movement in the price of a security or portfolio on both the upside and downside. From history, we know that stocks have earned a higher return than bonds and cash, but there’s no free lunch. To achieve those higher returns, you must be willing to bear stock price swings (volatility) greater than bond or cash (money market) volatility. So it's possible to have an investment with a lot of volatility that still has made money. Volatility is often used in the press to refer to price fluctuations during a fairly short time period-a day, a month, or a year. Such fluctuations are inevitable once you venture beyond CDs and money market funds. If you're not selling any time soon, volatility isn't a problem and is actually helpful. It enables you to buy more of a security when it's low, relative to its fair value. It’s true there is very little investment risk in holding cash equivalent assets, but there is also very little chance of keeping up with long term inflation.
The key factor that links the daily volatility of your investments and the chances (risk) of reaching your financial goals is TIME. The shorter your time horizon, the more asset volatility becomes an issue. And the more volatile an asset, the more that investment needs to be actively managed.
Being clear about your time horizon can help you gain comfort with the level of your portfolio risk and the breadth of market swings. We believe now is the time that potential gains are the highest. The key is stepping back, reflecting, and discussing your real risk tolerance. For most people, priorities lay with achieving financial goals and generating the income necessary for a comfortable retirement. As money managers and financial advisers, we can quantify the level of portfolio risk that will help you get the most out of your savings and investments. Call us if you have any questions.
Many investors consider U.S. Treasury bonds risk free. However, if you buy them when long term yields are very low you can suffer a substantial loss in a treasury fund when rates go back to historical levels. Last quarter the 10–year treasury yield hit its lowest point of the year. Investors bid up treasuries amid market jitters over Europe and the pace of economic recovery. So what do you do if you are looking for yield? We view potential downgrades amidst the current state budget crisis as an opportunity to buy investment grade Municipals. We are confident most states will be able to meet their interest and principal payments as opposed to smaller municipalities. In the past, our perception was municipalities would be slow to raise taxes. This is not the case. While both states and countries have taxing authority, states are required to balance their budgets and countries are not. In addition, U.S. investor demand for municipals is likely to accelerate in the second half of this year as investors anticipate the expiration of the Bush tax cuts. With the upcoming release of the 2011 fiscal budget, now is the time to buy investment grade municipal bonds. Click here for information on municipal and Build America bonds. Call us to see how we can generate tax-free income for you in this low interest rate environment.
Who wins under the Financial Reform Act that was just passed by Congress? Investors! The sweeping bank reform bill approved last month is the most significant change to the regulation of U.S. banks since the great depression. These reforms place new restrictions on the nation's largest banks, rein in the Federal Reserve and craft a new consumer protection division for mortgage and credit card products. In addition, brokers now have to adhere to the same fiduciary standards as we do at Karp Capital. Until now, brokers have been subject to less stringent suitability standards. There is a difference between selling product which is produced by a firm and helping to guide a client to make good financial decisions. This has been part of the Karp Capital client creed since day one.
During the quarter we witnessed a disconnect between company earnings and sector and stock performance. We saw volatility and emotions run high from the streets of Greece to the Gulf. This collapse in confidence played out in the stock markets on May 6th. The Dow Jones Industrial Average Index briefly dropped nearly 1,000 points but recovered strong to close down 347.8 points. Early reports that day tied the drop to the turmoil in Greece, but it was likely due to selling for other reasons. The evidence points to traders and others who seek to profit by trading on very small changes in price. They use super fast computers to continuously analyze prices and place orders in milliseconds on the market exchanges. Once prices moved enough, other investors who operate with longer time horizons than a few seconds were drawn into the market, creating a tidal wave of orders and more extreme price moves. In theory there are circuit breakers across the U.S. exchanges that prevent systems from the so called flash crash. The flash crash showed how interconnected we truly are and how confidence in the system is more important than what a company earns. We need to rebuild faith in our financial system and our leaders. In part, this means we need to strengthen and enforce exchange rules and procedures so that investors globally will continue to have confidence in the fairness of the operation of the U.S. markets.
 |
Health = Head, Heart and . . . ART Physicians, clergy, self-help gurus, all encourage us to find balance in our busy lives. Understanding the rational and emotional elements that make us who we are is not easy. When philanthropy is part of our investment plan, we have a natural way to exercise head and heart – charitable giving. There are countless worthwhile organizations to choose from, ones that deserve our time and financial support. I know many of our readers are active philanthropists. One of my own favorite nonprofits (full disclosure: I serve on its board) is ELDERGIVERS. They operate a remarkable art program for seniors in the San Francisco Bay Area – Art With Elders (visit www.eldergivers.org). My office is adorned with artwork from this program, like the sample shown here. It reminds me, in the midst of a hectic workday, of the elders who have brightened my life and of the underlying value of art to our society as a whole. I hope you’re discovering the balance in your life that you deserve. If you would like more information on the financial benefits of charitable giving, click here. |
|---|
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 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 |
If you no longer wish to receive the Karp Capital Management Focus newsletter, please contact us