PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr (0.57%) (3.81%) (10.98%) 2.09% (15.36%)
2nd Qtr 1.75% 2.99% 15.92% 19.42% 20.23%
YTD 1.17% (0.94%) 3.15% 21.92% 1.77%

FMR taxable and non-taxable retirement portfolios outperformed the S&P 500 during the first half of 2009 with the typical account holding approximately 10% cash at the end of the second quarter. The stock market staged a huge rally from what we believe was the lowest low of this financial crisis on March 9th (676 for the S&P 500). The S&P 500 index increased +35% from that low to 919 at the end of June, a stunning move that surprised many of the “perma-bears”. Second quarter FMR performance underperformed this record setting snap back rally. The reason for lagging in the recent quarter is that most portfolios remain defensively positioned with both cash reserves and a significant focus on income producing stocks. We expect these reserves will be redeployed in equities over the summer. Our thinking is that the market will give back some of the advance as economic issues will bring into question the timing of an upturn.

It is worth repeating an important observation from our first quarter letter where we said that at the gloomiest bottom, stocks are less risky and potential returns are higher. Four trillion dollars sitting in cash earning less than one half of one percent was and is unsustainable as a status quo investment policy. The stock market always leads the economy out of a recession, and once again this historical observation is holding true. Let’s review the “green shoots” (descriptive, albeit overworked in recent financial commentary - we promise not to use it ever again!) that have developed in the second quarter and update where we stand on the four problem areas of the 2008 financial crisis and “Great Recession” i.e., Banking, Credit markets, Employment and Housing.

We are optimistic that we have seen the worst of this economic recession in the first quarter of 2009 as GDP was revised to show a smaller decline. With a nice rebound in real consumer spending in the second quarter the probability is high that this quarter’s GDP decline will be less than expected (estimated at -1%). The quarter that just ended will mark nineteen months as the longest post World War II recession. However, this does not mean that we are on the road to a robust recovery but rather that most of the “bad stuff” has already happened to the U.S. economy. As we discussed in our first quarter letter, the recovery, as it unfolds in the second half of this year, will be quite bumpy and not feel like a recovery, some sectors will improve and other sectors will lag or retreat further. There will still be plenty of negatives in the news (lagging indicators like unemployment), but the markets will continue to discount the past and look for marginal improvements in the business, and profit outlook in sectors and companies that have navigated this storm successfully. We believe that the third quarter GDP could be flat or up a little and that fourth quarter GDP will be positive.

The optimistic developments and observations in the second quarter include:

  • Enormous fiscal and monetary stimulus applied simultaneously around the world.
  • Inventories of finished goods significantly below normal should provide growth in the second half.
  • The yield curve, with short rates near zero and long rates that are low, provides a supportive background for housing. Single-family housing starts are up 12% in the U.S. Permits and mortgage approvals are up from Spain to Australia.
  • There are many signs of strength overseas with export orders and employment up in Taiwan, Korea, Turkey, and there are even some signs of life in beleaguered Ireland as real retail sales have recently increased.
  • Temporary employment numbers have recently increased.

Additionally, the restart of our car companies’ manufacturing plants this summer supported by the “cash for clunkers” program, together with the effects of the first-time home-buyer tax credit, will add support to this economic bottoming process and modest upside growth scenario.

Where does this battered economy stand on Banking, Credit, Employment and Housing as we turn to the second half?

First, the Banking crisis has moved from the operating room into intensive care (and regulation) with some of the stronger banks now in recovery, repaying their TARP loans and looking to resume profitable growth. The complete recovery for the entire banking system will most likely take at least another year as there are still bad loans and assets that have to be written off along with new equity raised to strengthen their balance sheets. The good news is that we have turned the corner and the capital markets are opening up for the necessary refinancing.

Second, the Credit markets have continued to heal since the first quarter with new debt financing and roll over refinancing much more available to high quality companies. The jumbo home loan mortgage market, and the commercial real estate debt-markets, are still quite limited and will only recover slowly with additional help from the FED and conviction that we can sustain a recovery. The credit and currency markets are rightfully very concerned about fiscal irresponsibility as our government continues to pile up trillions of dollars of government debt. Tax increases on income, dividends, capital gains, and electricity (cap and trade) along with increased state and local income, property, and sales taxes are not the way out of this unprecedented deficit. World economies and markets will react positively if they see disciplined and well thought out national policies. Restoring confidence in our trading partners (particularly China) that we will prudently cut this deficit is paramount to sustaining any decent recovery in both the economy and the stock market.

Third, Unemployment is a lagging indicator and is likely to reach the 10% level as soon as the current quarter. If there is a whisper of relief it is that employment could turn up sooner than expected as employment declines have improved by about 400,000 over the past four months. Because the consensus expects our unemployment to get even worse, perhaps 11%, our policymakers will undoubtedly keep trying to create jobs from more government spending. This approach has little chance of success as permanent job growth comes from innovation, increased productivity, lower not higher taxes on business, and incentives to invest in new capital equipment. Without sustainable private job creation there will not be a significant and stable recovery.

Finally, we believe that we have reached an inflection point in the Housing recession. New home sales have actually increased 4% from the low and existing home sales are up 6% from its low. A return to a nationwide normal housing market is unlikely until 2011 but the good news is that real estate is local and, excluding the formerly seven to eight red hot bubble housing markets such as California, Florida, Nevada, and Arizona, most of the housing markets throughout the U.S. (two-thirds of the states, Case-Shiller study) have remained relatively stable despite the severe correction in the high-profile markets. With pricing down, and incomes stable, the affordability index for purchasing homes is excellent in the vast majority of local markets. The recovery in the sector that started this crisis will be a necessary condition to sustaining the modest recovery we now forecast.

How do we see the stock market, valuations, and outlook for FMR portfolios for the second half of the year?

During the March lows, we forecast that the S&P 500 could appreciate 48% to 1000 within 24 months (1Q of 2011). While seemingly bold at the time, this forecast actually appears quite modest in hindsight because of the compressed nature of this huge second quarter upswing. We did not expect such a violent upside move in only three months and since the market is now back to what we perceive as fairly valued, it would not surprise us if we give some of that upside move back over the summer. Achieving this 1000 target price on the S&P 500 sooner than our original forecast seems more realistic now but most of the major issues we have highlighted in our letter will need to be satisfactorily addressed to make this target a reality. Price earnings ratios that were too low in March are now reasonable at about 15 times forecasted earnings, so we think the market will tread water in a trading range +/-5%-10% around 900 as investors watch how our policy makers address our systematic problems. In the roller coaster, bumpy economic recovery that we expect over the next half year, it is not unreasonable for our portfolios to be up anywhere from 10%-12% for the year.

We would be remiss if we did not mention the continuing importance of reliable, growing dividends. With few exceptions, the vast majority of our holdings are paying out significant dividends as they are more important than ever as a source of both income and total return. Many of our companies are throwing off cash yields of 5%-8% that compare very favorably with the low returns available on money market funds. After a brutal 2008, dividend paying companies are outperforming and providing lower volatility to our portfolios along with a real “cash” income stream. Our strategy will continue to look for, upgrade, and hold those companies with the best competitive economic franchises, strongest balance sheets, and excess cash flow where there is a management commitment to pay dividends to shareholders. We continue to hold approximately 10% cash reserves in most portfolios to allow us to add to existing names on weakness or to add a new dividend paying company that fits the above criteria. We want to emphasize that the lower stock prices we have today, versus one to two years ago, imply less risk for owning equities, not more risk. Today, even with all the uncertainty we have discussed, we would much rather own a critical infrastructure asset such as a natural gas pipeline (Kinder Morgan Energy Partners) where the fees for putting natural gas through that pipeline pay us a growing 7%-8% quarterly distribution rather than a U.S. treasury bill paying us 0.05%.

We are enclosing our Privacy Statement and our Proxy Voting Procedures in this letter. We welcome your comments and questions at any time.

Sincerely, 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 assurance that investors will not incur losses.

Please remember to contact Five Mile River Investment Management if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations. Please also advise us if you would like to impose, add, or to modify any reasonable restriction to our investment advisory services.