Happy 2012

With all that transpired around the world in 2011 we are reminded of the proverb, “May you live in interesting times”. As we ponder the year ahead we wonder if these “interesting times” have passed or are still unfolding. Two years beyond the global recession, the outlook is far from stable. In fact, 2011 was marked by some of the worst financial and human crises in recent history. The sovereign debt woes in the Eurozone wreaked havoc on global capital markets. Political brinkmanship in Washington over increasing the debt ceiling contributed to heightened market volatility as well as the Super Committee’s failure to reach agreement on deficit reduction. Japan’s earthquake and tsunami left the country devastated and disrupted global supply chains. After a pronounced slowdown in U.S. GDP during the first quarter of 2011, it looked as though significant economic headwinds would continue to hamper the markets. However, surprisingly good news is starting to emerge. Corporate sector profits were robust and a positive contributor to the U.S. economy. American consumers continued to spend (but at lower levels than recent historical highs) helping to spur the economy and provide stronger than expected economic activity. The housing market is stuck at the bottom of a deep trough of price declines, yet housing affordability remains near all-time highs. The labor market remains a concern, but recent trends suggest a gradual improvement in hiring conditions. Against this backdrop, we will outline our investment strategy and financial planning agenda for the first quarter of 2012 for our clients.

Market Performance

Here are the performance numbers for the major indices as of 12/31/2011 (total return):

When the Going Gets Tough, Look to the Consumer, Not Uncle Sam

2012 appears to be another year of challenges and transitions. The upcoming presidential election and the potential breakup of the European Monetary Union are just two curves in the road ahead. Slowed government spending and political gridlock are destined to be setbacks in an election year. Economic fallout from Europe is sure to leave its mark and will likely stall U.S. exports in the first six months of 2012. So don’t count on government action to provide the primary stimulus to U.S. or global growth.

Fortunately, the other major driver of growth, consumer spending, may be gaining new sea legs. Consumer spending accounted for 71% of GDP in the third quarter. While the overall level of consumer confidence remains depressed, the economy did get a bit of early holiday cheer from consumers in the last quarter of 2011. The Consumer Sentiment Index for November showed its largest increase since April 2003. Consumers are also optimistic about job prospects; potentially this translates to a greater willingness to spend money they have saved. In addition, U.S. banks showed some increased willingness to lend in the last quarter of 2011. If this continues, it would also help spur the recovery.

Our outlook for 2012 is for moderate growth in consumer spending but, we hasten to add, this is tempered by several concerns. The data does not point to a robust gain in hiring in 2012. Household net worth fell in the second and third quarters of last year, as did household debt. The degree of debt reduction is unprecedented. Consumers have less and are spending less, but with the current strength of the dollar each dollar goes further. The cost of gasoline and other essentials priced in dollars has moderated. The combined impact of soft employment conditions, historically tight credit, and the continued shedding of household debt is an obstacle for consumer spending in the coming year.

Exports and Opportunity

As the Eurozone economies slowed and China’s exports to that region tapered off, the People’s Bank of China changed its bias and eased reserve ratios. Since the European Union imports more Chinese goods than the U.S., events there give China genuine concern. It is not a coincidence that Beijing officials have offered financial support since 2009 to troubled EU economies and purchased significant amounts of their debt. In light of recent events, the People’s Bank of China policy is becoming more accommodative to offset an expected Eurozone recession in 2012. Even though the long term prospects for growth are intact, there are a few significant issues to contend with that will cause growth to slow. Consequently, we sold our China holdings in the fourth quarter of 2011. We want to see how the European debt crisis and the real estate supply and demand imbalances in China play out.

India, however, is another story. The world’s largest democracy posted growth figures around 8% at the beginning of the year with inflation coming down to 9% from its 16% high at the beginning of 2010. Despite this, not all the news out of India was positive: a poor agricultural season led to shortages and resulted in escalating price pressures. The Reserve Bank of India (RBI) was caught between fighting inflation and promoting economic growth. While it chose to pursue price stability, its approach was ineffective. The economy slowed, prices rose and the RBI had little enthusiasm for cutting rates. Exports only account for 25% of India’s GDP, versus 50%+ seen in the more export oriented regional economies. India is not a major trading partner with Europe as it relies more on the U.S. and its Indian Ocean neighbors. This mitigates India’s involvement in the Eurozone’s problems. Indian growth and price stability depends on domestic balance, particularly with regard to food. We believe the Indian economy will struggle to post 4% growth through the first half of 2012. If inflation does not come under control during that time, the potential growth rate could falter and last the entire year. India, like other major markets, impacts what happens in the U.S. That connection drives our investment thesis. We will keep a keen eye on events in India as it represents some potential investment opportunities, but for the time being we think it’s better to remain on the sidelines.

The Fed – Read Between the Lines

Now is the time for the Federal Reserve to go on the offensive. The Federal Open Market Committee decided to keep the federal funds rate at a record low. The FOMC said that recent improvements in the economy came in spite of what it termed a deterioration in global conditions. The committee remains very cautious in its outlook, noting that there is continued risk of a further European meltdown undermining economic recovery. With mounting evidence that the U.S. economy is improving, the FOMC was clear it will take no new steps to boost economic growth in 2012. In other words, the Fed is pushing investors to move out of cash and invest in growth assets as interest rates will stay low for an indeterminate amount of time. There are indications that the economy is gaining traction. Initial jobless claims in December came in at a surprisingly low 366,000 versus an expectation of 390,000. Inflation also appears quite tame with the Consumer Price Index for November showing no growth. Since the end of September, small caps have been quietly outperforming. This can be interpreted as yet another indication that economic growth will be sustained in 2012.

The Cost of Uncertainty – Are Interest Rates Headed Higher?

In November, the Joint Select Committee on Deficit Reduction announced its failure to reach a bipartisan agreement. The lack of a compromise has both tax and investment implications. The most obvious relates to our country’s deficit. Though current legislation calls for $1.2 trillion in cuts to be triggered in 2013, some members of Congress are already looking for ways to stop them. Of greater concern, we remain without a long term plan for bringing down our deficit. This has the potential to drive up future interest rates. Exemptions for the alternative minimum tax (AMT) will shrink considerably in 2012 if Congress does not pass yet another AMT fix. The uncertainty of tax rates and deductions makes planning difficult for both individuals and businesses. From the standpoint of investors, the lack of tax clarity creates more headwinds with the potential to slow the pace of economic and earnings growth. To further compound matters, 2012 will see a presidential election. A divided Congress combined with a hard fought election and special interest advertising do not provide conditions conducive to revamping the tax code and creating a pragmatic solution for reducing the country’s debt. We do not expect to see meaningful developments on this front until 2013.

The European Sovereign Debt Crisis

We do not believe the Eurozone will collapse within the year, largely because the political fallout would be so severe and the financial cost would be prohibitive. Even so, there is a small risk that Europe’s leaders will fail to find a way out of the past two years’ political and policy paralysis, pushing Europe into a possible depression and possibly taking the global economy with it. Optimism over the Euro Summit last October was short lived. The bottom line is that the summit was long on talk and short on substance. It is now costing Spain and Italy more money to finance their deficits as interest rates continue to climb. There is also a mismatch in competitiveness and cooperation between Germany and other European economies. The Eurozone has succeeded in creating a close economic and financial sector linkage across its 17 members and dissolution would impose staggering costs on all concerned. Member governments will think they have little choice but to impose fiscal austerity that normally would not be considered at a time when recovery is still so fragile. We reduced our overweight exposure to Europe last fall and we will continue to minimize investment exposure in the region.

One critical point that is essential for investors: the European banking system will likely be bailed out just as the major U.S. banks were in 2008. European nations are trying to reach a political compromise to solve crushing fiscal problems created by free spending, social service oriented governments. This approach places a low priority on long-term responsibility to bond holders and now the bond holders are demanding higher interest rates to offset the irresponsible policies. Keep in mind that banks are among the biggest bond holders and if bonds are not repaid, then banks will fail unless there is a large infusion of rescue capital. Given the circumstances, there’s little doubt that European sovereign debt will continue to be downgraded by the credit agencies. The banking system’s survival is in everyone’s interest, especially politicians. Without banks there is no easy mechanism to raise money through bond sales. A strong banking sector is imperative for any country to prosper. It then comes as no surprise that in our opinion big banks reeling with sovereign bond debt will be bailed out.

Higher Market Volatility Requires Flexibility

In the past, there was a sense of sanity governing global financial markets. Now, each morning brings apprehension about the direction of the markets. Upon waking, we check the overnight performance of the Asian and European markets and anticipate the movement of our own markets. This is a very difficult environment in which to manage money. One of the better indicators of the level of market uncertainty and volatility is the VIX Index. The VIX Index has looked like a forward moving tsunami since August, when the rating for U.S. Treasuries was cut and the European debt crisis expanded. Since then, volatility has nearly doubled. When the VIX has risen dramatically, the market has tended to sell off. In fact, that negative correlation has increased over the last decade or so. This has presented us with additional challenges for putting new money to work. On the one hand, modern portfolio theory* suggests that the higher risk premium that should be paid for more speculative assets means such stocks deserve a place in the investor’s portfolio. On the other hand, selecting the price at which you are willing to establish a new position in a stock or add to that exposure becomes fraught with the danger that, in hindsight, you have overpaid, as price movements display that heightened volatility. Because of this, we have implemented some new tools and techniques we have not used before. We do not know how long this higher volatility regime will last, but we are prepared to address it as long as it does. The notion of long-term buy and hold regardless of market conditions can produce poor results if one’s time horizon is anything less than a generation.

We continue to customize our approach for individual clients and the type of assets (taxable, pension, etc.) you have entrusted to us. For example, as you approach retirement, your tolerance for losing hard earned wealth declines and makes sense to move out of riskier assets into safer ones such as fixed income and other products that produce a safe fixed annuity-like income stream. In the life cycle approach, the secure investments (fixed income and annuities) should provide distributive income while riskier assets such as equities can either be liquidated for emergencies or passed on to the beneficiaries of a client’s estate. As you approach retirement it is important to gauge your income needs. A portfolio needs to be adjusted over time in order to generate the income needed for retirement. Call us to see how we are adjusting portfolio construction to manage risk in your portfolio.

*Modern Portfolio Theory - A theory of portfolio construction that aims to optimize or maximize an investor’s expected return based on a given level of market risk. The theory asserts that the risk of a particular security should not be looked at on a standalone basis, but rather with respect to how that security's price varies in relation to other assets in the portfolio.

Not your Father’s Annuity

For those who were betting on elevated portfolio returns to help them reach retirement goals, time is running out. The median age of the U.S. boomer is 56 with the oldest members now in their mid 60s. The median age was 42 at the start of the tech wreck. When the financial crisis began, it was 52. Given the current low interest rate environment and the prospects for higher taxes in the future there are annuities that might help you attain your savings goal. Also, with numerous potential tax changes on the horizon, now may be a good time to consider adding more tax deferred investments to your portfolio, especially if you are in a high tax bracket. One way to help combat the tax pinch is to replace some tax-inefficient investments held in taxable accounts with suitable alternatives held in tax-advantaged accounts. It is important to keep in mind that with a tax-deferred variable annuity, all gains are taxed as ordinary income upon withdrawal, and an additional 10% IRS penalty may apply to withdrawals taken before age 591⁄2. Call us to see if adding an annuity program is right for you.

All of us at Karp Capital Management thank you for your continued support over the last year. It is a privilege to help you, your family and friends reach financial goals. 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.Securities offered though Financial Telesis Inc. member FINRA/SIPC. Karp Capital Management is not an affiliate of Financial Telesis Inc.