Taxable Estimated
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr (6.40%) (5.81%) (9.44%) (14.53%) (10.19%)
2nd Qtr 3.61% 4.33% (2.67%) 3.10% 0.25%
3rd Qtr (15.79%) (13.74%) (8.36%) (13.20%) (1.46%)
4th Qtr (24.45%) (29.30%) (21.95%) (24.61%) (26.51%)
YTD (38.30%) (40.08%) (36.99%) (40.54%) (34.80%)
“It’s not that panickers (sic) realize it’s time to stop panicking. At some point all the people who are going to panic and sell have done so.” This quote from Brian Bruce, editor of the Journal of Behavioral Finance and CEO of Hillcrest Asset Management, hits the nail exactly on the head as a fitting epitaph to the investment markets of the last four months of 2008. Irrational investors can and do set the prices in the short-term, and as we said in our December update, the distressed stock market of this past Fall was as disconnected from the long-term fundamentals as we have seen since the 1973-74 recession and bear market (down 45% over 694 days starting January 11, 1973). Whether you are a professional investment advisor or an investor, young or old, working or retired, one is certainly compelled to evaluate what happened to the investment and credit markets last year and put it into context with their own financial position, investment objectives, time horizons, and tolerance for short-term volatility. The overwhelming majority of investors and investment professionals experience in today’s markets does not pre-date WWII, and as we have previously called 2008, this was a perfect 200 year storm worldwide. The most important point to remember during this period of uncertainty is to not make permanent long-term investment changes that jeopardize your future financial stability when the pain, suffering and fear are at their worst. The sickening downward churn and uncertainty finally comes to an end in all bear markets and we have had recoveries from every recession, including the debacle of the 1930’s

While we have written about what we were seeing as it was happening throughout 2008, our belief that we had adopted a more defensive position at the beginning of the year through the use of higher yielding dividend stocks and master limited partnerships with high and growing yields ultimately did not provide any protection. Virtually every industry, sector, and asset class except U.S. Government Treasury Bonds and Notes went down simultaneously this past Fall. The S&P 500 was down 37% in 2008 and 22% alone in the fourth quarter. FMR portfolios were down 38%-40% for the year and between 24%-29% for the last quarter depending on account objective and whether taxable or non-taxable. The S&P 500 has lost more than a third of its calendar year value only twice before in the last 90 years, both during the Great Depression. It fell 41.9% in 1931, and 38.6% in 1937. The worst post-Depression year, until now, was 1974 when the market fell 29.7% in what, until now, was the worst postwar recession. As bad as this was in 2008, leading indices in the UK, France, Germany, Canada, Mexico, Brazil, China, and India all lost more than 50% of the their value measured in dollars. Japan was down 40% in dollars but almost 50% in yen. The point of these statistics is simply to put this decline into context, namely that this data already matches or exceeds historical extremes (1932, 1974, 1982, 2002). As we said in December, nobody “rings a bell at the bottom” and we were not sure that the panic selling of November was over, but that we were not likely to go too much further down than the November low even though the stream of negative economic news continues and will continue for at least several more months. The intraday low for the S&P 500 in 2008 and so far in 2009 was on November 21, 2008 at 741.02 and as we write this letter, the market is above 930, up over 20% from that low. As many of you have pointed out to us, this could be nothing more than a rally in a continuing bear market and that we could easily retest that low again this year. We do not argue with that point and it is certainly plausible and possible as the end of the selling is never obvious at the time that the “panicking finally stops.”

The S&P 500 more than doubled in the year following the 1932 Depression low, and tripled off of that low within less than three years. Markets always bottom out and start their recovery when the TV and newspaper headlines are their gloomiest. We can all now see that the news is lousy and expectations are for the poor news to continue throughout 2009. It is in that kind of environment, when the economy looks the worst, that a turnaround begins. The headlines today are telling us what happened last month or last quarter, not what will happen in the future, and the stock market always leads economies out of recessions, not the other way around!

Trying to keep the historical underperformance and undervaluation of 2008 in perspective, what, if anything, can we see for 2009 that will be helpful in investing wisely for the future? Will Rogers is quoted as having said he was much more interested in the return of his capital than the return on his capital. Despite 2008’s disappointing performance, we are concerned about both the return of and return on your capital. As many of you may know from your own experience, the auction of Three-month Treasury Bills in December carried a yield of zero and some Treasury issues actually traded at negative yields! Certainly that epitomizes the extent of the fear we have been discussing but the corollary to this unbelievable zero rate of return is that common stock dividend yields in absolute terms yielded more at 3% than Ten-year Treasury Bonds (2.5%). The last time the S&P 500 yielded more than the Ten-year Treasury Bond was 1958. While seemingly counterintuitive in the current environment of panic, stocks are less risky today than one year ago or two years ago in relation to Treasuries, the only outperforming asset class for 2008. Reversion to the mean from extremes typically does happen and it is possible that the market has put in a good bottom as we write this letter to you in early January. We believe the snowball effect of self-reinforcing negativism of this past year is largely behind us with the lessening in the “panic selling” we witnessed all of last Fall. While volatility is still historically high, the key measure of this volatility has dropped significantly over the past few weeks and we believe, at least, that it sets the stage for a trading range above the November lows, albeit perhaps for an extended period of months. Because of major governmental policy mistakes over the past ten years, this current recession, which has been going on for more than a year, will be longer and deeper than anything we have seen post WWII. While this makes forecasting the timing impact of all of the recent and yet to come Federal Reserve and Treasury stimulus more difficult, is does not preclude yet another recovery from a recession in the U.S. Our best guess is 2010, given the probable depth of this recession.

Government policy of the 1930’s exacerbated the length and depth of the Depression as was also true for the Japanese in their lost decade of the 1990’s. These same mistakes are not likely to be repeated given the study and understanding by Chairman Bernanke and other prominent economists. This does not mean that our government will not find new ways to make mistakes but enormous errors on the scale of these two very different periods (monetary tightening, trade protectionism, insolvent banks) seem highly improbable in the current climate of activism by our monetary authorities and our politicians. Disappointing corporate earnings for several quarters or even a year or two does not change the long-term value inherent in companies with dominant business models, competitive positions, solid balance sheets, free cash flow and management whose interests are aligned with shareholders. As an example, we hold IBM in most of our accounts which has a pristine balance sheet and a very strong competitive market position. The high on the stock in the past twelve months was about 130 and the low around 71 this past Fall. The current price is approximately 88, up 23% from its low less than two months ago. The question we ask ourselves as long-term investors is whether the long-term earning power, or normalized earnings for this company has been permanently eroded by the current recession and several slow quarters, and perhaps a slow year in 2009. Is this a substantially different company at 71 than it was a year earlier at 130? The answer for IBM and for many other high quality companies dumped this Fall is emphatically NO. What is different is that the lower stock price means that expected future returns from purchasing IBM today will be higher than a year ago. At a 25% discount to the market multiple, could IBM earn $10.00 in 2010 as the economy begins to recover and grow and sell at 10x price earnings multiple or 12x? That would result in a price of $100 or $120, up 13%-36% from its current price in the next 12-18 months. That kind of appreciation plus about a 2% dividend is not world beating, but it is highly likely to beat a zero rate of return on Treasury Bills or even a 2.5% return on Ten-year Treasury Bonds. While consensus today might say this is too risky a bet to make because of the duration of the recession, we would argue that this investment is actually less risky than a year ago and less risky than investing in a 2.5% yielding Treasury Bond because: one, the valuation is more reasonable, and two, future inflation could erode the value of your low yielding bond.

Finally, we would like to wrap up with a few thoughts about dividends, tax policy, long-term investing and long-term market outlook. Our focus for the last few years was to continue to find investments with above average dividend yields or distributions and growth in those dividends. Throughout the second half of last year, we took tax losses in several positions where we could find a higher quality replacement company with equally or more attractive growth and dividend prospects. We have commented in the past that over the long haul, dividends have provided about 40% of total market returns and in some years much more. Dividend stocks did not hold up as we thought they would in the fourth quarter market sell off, in part because of concerns about how an Obama administration would treat income investors by raising the 15% tax rate on dividends along with capital gains. While the bad news is that income tax rates for families with incomes above $250,000 annually will see their rates in the top brackets likely go back to 36% and 39.6% with the expiration of the Bush tax cuts at the end of 2010 or possibly sooner, the good news is that Obama’s current plan is to only raise the federal tax rate on long-term capital gains and dividends from 15% to 20%. Under current plans, dividends will not return to being taxed at ordinary income tax rates. While this change will not increase the government’s revenues by the amount expected, this policy change could clearly have been more negative and does not substantially change the reason for investing in common stocks and companies who pay dividends. This outcome should lead to further recovery in the higher yielding dividend stocks that we have used in both balanced and growth accounts, as well as, our income only investors.

We characterize long-term investing as a time horizon of five to ten years. While diversification in high quality dividend paying companies did not insulate your portfolios from a decline last year, we would like to repeat that there has never been a 20 year losing period in a diversified portfolio. The last ten years for the U.S stock market from 1999 has basically produced a negative return for most investors and a positive return for value oriented dividend investors. Short-term technical trading that sold investors out of the market last year certainly looks good in hindsight and reduced anxiety for those investors in cash during the meltdown, but they now have two problems. How easy is it to consistently time the tops and sell and then get back in at the bottom? First, it is very very difficult to make these decisions, and second, you have to make two decisions, not one. Nobody right now can predict what level corporate earnings are going to be during the remainder of this recession. Assuming the recession lasts throughout 2009 with only modest recovery in 2010, normalized corporate earning power for IBM and many other companies has not been permanently impaired. A return to normalized earnings for a 2%-3% growth economy and a normal historical price earnings ratio on those recovery earnings in 2011 would give you a range on the S&P 500 from a low of 1000 to a more reasonable price of 1200 (approximately 900 today) and still be 300 points under the 1500 peak for the S&P 500 in October of 2007 and 350 points under the March 2000 high of 1550. Even this conservative estimate for 2011 gives you anywhere from a low of +11% returns with dividends to +30% over the next 18-24 months as markets always lead economies out of recession by anywhere from six to twelve months. This very possible forecast does not in any way require the market to return to the bubble years from the mid 1990’s with price earnings multiples for the market in the high twenties and even in a couple of years over 30 times earnings. Our estimates assume a price to earnings multiple of not more than fifteen times for the market over the next three years and it is probably prudent to assume that this is the norm for as long as the next five years.

To conclude, we hope this somewhat long review of where we have been and how you should be thinking about your asset allocation and investment objectives has been helpful and that this maximum uncertainty comes to an end in 2009 with a calmer market and hopefully strong leadership out of Washington.

We value our relationship and the confidence you have placed in us over the past several years. Thank you for your patience and support and as always, feel free to call, email, or visit with us at any time with your questions and comments. We would also be glad to set up a conference call with you and your family members for a more extended discussion. Our best to you and your families for a healthy and happy New Year.


Lee Todd Martha

*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 interests in any securities may be made only by means of delivery of a Five Mile River Investment Management Agreement and or other similar materials which contain a description of the material terms and various considerations and risk factors relating to such securities or fund. 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, and there can be no