Taxable Estimated
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (6.40%) (5.81%) (9.44%) (14.53%) (10.19%)
Extreme volatility in all financial markets was the hallmark of the first quarter as the twin bubbles, housing and credit, negatively impacted virtually every kind of market around the world. The S&P 500 moved more than 1% on over half of the trading days in the first quarter, the biggest percentage since 1934! While the Dow and the S&P 500 did not reach the 20% peak-to-trough decline normal in a bear market (-17% & -19.4%), the NASDAQ and the Russell 2000 small cap index did drop over 20% from their highs in the second and third quarters of last year. Technical definitions aside, this decline felt and acted like a bear market, as the recent five month decrease was the most severe since 1990; the S&P 500 saw a -9.44% performance for the quarter, the worst decline in over five years. The performance for our taxable and non-taxable accounts in aggregate was -6.40% and -5.81% for the first quarter. Our more defensive posture mitigated some of the downside but clearly your portfolios were impacted by the broad market decline.

As we have written repeatedly over the last several years, we have made significant investments in companies that have business models permitting them to pay out substantial growth in dividend income. While this focus has performed at times both offensively and defensively, the capitulation we saw in the first quarter took these names down irrespective of their dividend yields or growth potential. Specifically, we saw electric utility names and many master limited partnership holdings drop by double digits in the first quarter. Growth names with even a hint of economic (or credit) sensitivity were battered as well. At the risk of appearing trite, bear markets tend to correct all names, with the best names often being hit last. We believe this was the case in the first quarter. Of interest, we have witnessed rebounds of almost half the first quarter declines during the first two weeks in April. We continue to emphasize those companies that have the ability to grow and distribute cash to shareholders since this strategy is the most time tested even in the face of markets such as these.

Every financial crisis seems in hindsight to have a specific event or focus that defined the darkest hour. For our current crisis, the poster child of this situation will most likely be the meltdown and takeover of Bear Stearns by JP Morgan Chase. In looking back at past financial crises, the “Sub-prime/Bear Stearns” crisis of 2007-2008 looks like a combination of the 1990 “Savings and Loan” debacle which led to a recession with a subsequent four year decline in housing prices, and the 2000 “Technology/Nasdaq” collapse that also led to a recession. Our forecast since last fall has been that we would have a mid-cycle slowdown with real GDP growth of zero to 2% for several quarters with a one in three probability of a recession. We are not inclined to change that forecast. Whether we are technically going to have a recession or not, as defined by two consecutive negative quarters of real GDP growth, seems to be a moot point. A majority of our consumers today feel and act like we are in a recession. The consumer accounts for roughly two thirds of our economy and the combination of the decline in housing prices (full cycle 15%-20%) and high energy prices has brought consumer spending to virtually a standstill except for necessities like food, healthcare and energy (miles driven is down 1.7% and gasoline demand down 1% year over year).

One important key as to whether we just muddle along the bottom at flat to 2% GDP growth will be the employment numbers which, while trending down for the past three months, are not declining at the magnitude we normally associate with past recessions. While employment will continue to weaken, there are important reasons why the U.S. should have better employment numbers than past recessions. The weak dollar has strengthened our exports where international companies are increasingly sourcing manufacturing purchases from the U.S. Also helping employment is the fact that large parts of the U.S. economy are doing well by participating in the record prosperity in both the agricultural and energy producing regions. The long-term correction and repair of the structural flaws in both our housing and credit markets are necessary preconditions for resumption of normal and healthy growth in the U.S. economy. Since the excesses in both markets took several years to develop, it will likely take at least two years to constructively fix the issues plaguing both markets.

As we look ahead to the balance of 2008 and into 2009 how do we see the financial landscape unfolding, and how are we positioned in your portfolios? Experience from past financial crises shows us that even with the recessions that came with the 1990 and 2000 situations, deleveraging and unwinding of speculative excesses accelerate once all market participants know they are actually in a crisis and have to take corrective actions. We have already achieved the recognition phase and have just started the fix stage in our current crisis. Unlike the ten year delayed reaction to the speculative real estate bubble in Japan at the end of the eighties, massive write-offs of bad mortgage paper have begun and will continue unabated throughout 2008. We believe the vast majority of these mark to market actions will be over by the end of the second quarter as the FED provides the necessary liquidity to restart the lending of money to credit worthy borrowers. As risk is better understood in these complex debt markets, realistic pricing will return gradually market by market. In addition, the level of liquidity the Federal Reserve has now made available to the banks will enable the debt markets to return to normalcy.

Our forecast for the U.S. equity market is that even with slow or no growth for the next several quarters, the stock market will anticipate the eventual end of the deleveraging and restructuring of our credit and housing markets, and will rally ahead of the turn in the economy. Since we expect a two year unwinding of our twin problems, it is not unreasonable to look for the market to begin to discount the end of this process during 2008. The wild card of unpredictable economic and regulatory policies coming out of this fall’s election add an element of risk and a note of caution to any forecast, including our humble attempt to see the future. We know there are lags in our huge economy for these corrective actions to effectively address all of the structural issues, but we also know that long-term wealth building requires patience and discipline particularly when the storm looks the worst. We believe it is too late to sell and that the current environment will have proven in hindsight to have been an attractive entry point for new equity commitments. Missing just a few of the best months over a market cycle from trying to time the market generally produces subpar performance.

The timing game is not one we know or are comfortable in implementing. What we do know about equity investing in times of uncertainty and volatility is the need for absolute return investments that produce free cash flow in companies whose business model is sustainable and profitable without significant debt. We have continued to position our portfolios more defensively by owning both attractively priced growth companies that are less sensitive to the business cycle and companies that own hard assets and long-lived assets such as trees, pipelines, railroads, and natural gas reserves. We look for companies whose managements own significant amounts of common stock directly, thus aligning their interests with shareholders, and companies that pay out a significant dividend stream that is growing. In our past letters we discussed many of our names in detail and we will return to that practice with our next quarterly letter. The first quarter was such a climatic and game changing quarter from so many different perspectives and thus deserving a more macro discussion. We appreciate your indulgence in wading through our lengthy overview of our financial markets and economy. We thank you for you patience and support during this difficult market and encourage you to call or email your questions and comments.


Todd Robbins Lee Garcia CFA

* The foregoing information is not audited and has not been otherwise reviewed or verified by any outside party. While Five Mile River Investment Management, LLC endeavors to furnish accurate information, investors should not rely upon the accuracy or completeness of this information.

This letter is not meant as a general guide to investing, or as a source of any specific investment recommendation, and makes no implied or express recommendation concerning the manner in which any client’s accounts should or would be handled as appropriate investment decisions depend upon the client’s investment objectives. Any offer to sell or the solicitation of an offer to buy any securities may be made only by means of delivery of a Five Mile River Investment Management Agreement. Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be either suitable or profitable for a client’s or prospective client’s portfolio.