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%
3rd Qtr 8.05% 10.31% 15.59% 16.36% 18.89%
YTD 9.31% 9.28% 19.27% 41.87% 20.99%

FMR taxable and retirement portfolios were up 8.05% and 10.31% in the third quarter and 9.31% and 9.28% year-to-date respectively. The broad market, as represented by the S&P 500, was up 15.59% in the quarter and up 19.27% for the year. Only six months ago, stocks were crashing around the world and financial panic was the order of the day. From what is most likely to have been a generational low in the market on March 9, 2009 (676 for the S&P), the market has risen 56% in only 147 trading days, the steepest climb since 1933. To keep this number in perspective, the market is still down 31% from the record highs of October 2007. Typically a violent panic on the downside subsequently reverses more quickly than expected in what the academics call “reversion to the mean.” Despite the severity and length of this recession, the stock market has recovered to a level that is now fairly valued on significant future earnings growth in 2010. The typical first year market recovery is about 38%, and the biggest first year recovery post WWII was 58% following the 1982-83 recession. We are modestly expanding our earlier market forecast of an up year of 10%-12% to an increase in the range of 10%-15% as the probability of the most onerous healthcare and environmental legislation becoming law is diminishing.

Where does this recovery stand as we look at the end of the year and into 2010? Chairman Ben Bernanke recently declared in testimony before Congress that this recession is over but cautioned that the road ahead would be uneven and difficult. To illustrate, here are some specifics:

  • World economies are experiencing unprecedented synchronized upturns across the board from China and India to Brazil and Turkey.
  • Employment declines and housing price declines are moderating (we did not say over) and consumer net worth has turned up with this large rally in the stock market.
  • Productivity is rising significantly from drastic cost cutting, leaving the U.S. economy with very low inventories and upside earnings leverage with revenue growth.
  • Real GDP plunged 3.9% in the four quarters ending last June, a post-WWII record, but the decline in real consumer spending only contributed 1.2 points to this overall 3.9 point contraction. Why? Although the media and most economists point to consumer spending as 70% of the U.S. economy, the real number for household “out-of-pocket” spending that drives economic activity is more like 40% (remove imported goods like consumer electronics and other non consumer items that are in the gross 70% number). Real GDP in the third quarter will be our first positive quarter in a year and should see an increase of 3% to 4% as the one time housing credit and cash for clunkers programs jump started these important sectors.
  • Interest rates should remain low for at least another year, with inflation in check, because of vast unused industrial capacity across virtually every sector and industry.
  • Real economic growth should slow somewhat in the fourth quarter, settling around an increase of 2% to 3% as these one time programs expire.

So why are we cautious after this unprecedented rally off the March lows? We believe the “easy money” has been made off this historical bottom, and the risk to the market is a very slow recovery in 2010 (an increase of 1% to 2% real GDP) as rising unemployment and high consumer debt act as a drag on real growth. A “sustainable” economic recovery in 2010 will have to come from a rebound in both industrial and residential capital investment following the current quarter’s one time spike from rebuilding inventories, and the “clunker’s effect.” It should be clear by now that the U.S. economy cannot expand with the value of housing going down. The more likely path for our economy next year is only a modest recovery with unemployment staying at 10.0% to 10.5% for most of the year, coupled with low inflation and low interest rates.

This “new normal” recovery will take significantly longer than we have come to expect as debt reduction for both the consumer and commercial real estate will be slow. Additional one time government stimulus two years into this recession misses the target of helping small businesses who create most of the jobs in the U.S. today. Unsustainable government spending distorts the process of making rational investment decisions by real businesses, and runs the risk of bringing on a prolonged period of stagnation. The government needs to back off and stop the “bailouts” and scale back its activist policies or we run the risk of repeating many of the mistakes that the Japanese have committed for the past 20 years. Federal stimulus spending is an oxymoron. Sending checks from the federal government to the private sector, whether through one time tax rebates, housing credits, food stamps, cash for clunkers, or unemployment insurance extensions does not have a sustainable effect that creates permanent jobs and a growing economy. The fact that we used tax or deficit dollars to buy cars does not mean the U.S. economy is turning around, especially since 60% of the car profit went to foreign auto firms! Each $1 increase in government spending reduces private spending by about $1, with no multiplier benefit to GDP. Unfocused government spending, that does not support real job growth, leaves the U.S. with higher deficits and higher interest on that federal debt. More burdensome taxes to support the higher deficits and interest on the federal debt will result in slower economic growth by squeezing out the private sector.

Today the U.S. has an estimated 15 million unemployed workers and still headed higher. The real number is closer to 26 million if “marginally attached” and part-time workers are counted. With a work force of about 150 million, these are “perfectly awful” numbers to quote former FED Chairman Alan Greenspan. We need 1.5 million jobs a year just to take into account population growth. Even if the U.S. economy was able to create 200,000 jobs per month for the next two years, unemployment would still be 9%. Small business owners, who face large income tax increases starting January 2011, create 75% of new jobs in the U.S. They will be slow and reluctant to hire new workers when faced with the daunting prospects of more taxes and uncertain impact of healthcare and environmental regulation.

With current policies (excluding healthcare and “cap and trade”), U.S. government debt will rise to somewhere between 70% and 80% of GDP, up from about 40% at the end of 2008 with long-term trillion dollar deficits. Foreign central banks hold over $2.6 trillion U.S. dollars, the largest component of world reserves. China and others have recently made it crystal clear that the U.S. role as the main world reserve currency is compromised by our Federal Reserve’s current policy of monetizing our deficits by printing new dollars. The current relentless decline in the U.S. dollar is a direct outcome of these policies. The question of whether our economy will languish in the next few years or experience a healthy recovery will be made clear by the policies coming out of the Federal Reserve, the Congress, and the Administration over the next six months. We, as investors, face a difficult predicament in this very uncertain environment and, therefore, we choose to follow a conservative path. We are cautious and remain defensive in FMR portfolios because we cannot predict the impact of these important policy decisions yet to come.

We are continuing our more conservative strategy of focusing on companies paying dividends, strong balance sheets, and free cash flow, along with maintaining 10%-15% cash reserves until the cloud of government policy recedes. Lower quality and non-dividend companies outperformed for the past six months from the March lows. Since the beginning of the year we have been much less concerned with “beating the market” and its relative performance than with preserving capital and generating a large and reliable income stream. Dividends have been unpopular this year while more speculative emotions carried the day for two quarters. As the first day of the third quarter started out with a modest 5% correction that many expected in September, we doubt that this is an opportune time to be chasing market momentum. So much cash on the sidelines earning virtually “0” will certainly continue to be an unpredictable wildcard in near term performance of the market. We believe that the market will reward strong dividend paying common stocks in the future. Disciplined stock selection at a discount from private market value will once again be critical as the emotional snap back phase appears to be over.

One sector comment and one stock comment.

We have been over weighted for some time in gas sensitive energy names and our enthusiasm for companies who explore, produce and transport natural gas continues unabated. The gas market is very likely to move from oversupplied to undersupplied by mid 2010 as the number of gas drilling rigs has dropped from 1600 to high 600’s, down 60%. While there is a reason to be excited that these new gas shale reserves will solve our gas supply issues forever, new shale wells decline an average of 75% in the first year compared to a 30% decline for average gas wells. As industrial sector demand for electricity and gas improves, along with a supply decline from 2008 peak production, pricing should firm and produce very high return on investment for strategically positioned companies in this sector like The Williams Companies, Inc. and XTO Energy Inc.

Finally, we have started a small position in DIRECTV, the largest U.S. satellite TV provider and the second largest Pay TV provider. The company has 18 million video subscribers in the U.S. and is growing its base with the delivery of high definition channels. Their exclusive contract for the NFL’s Sunday Ticket football package is a significant advantage in the market place. While current valuation of the DTV stock is fair, the catalyst for our interest is two fold. First, the closing of the merger with Liberty Entertainment (controlled by outstanding media executive, John Malone) is expected this month. Second, simplifying the public ownership and freeing up management to use $2 billion of free cash flow to buy as much as 25% of shares outstanding should create value for all shareholders. While our upside target implies a modest 15% return, John Malone’s end game for this valuable media asset could provide additional return in a tax efficient manner. It would not be surprising to see DTV establish a dividend post ownership consolidation, and it is not unreasonable to expect outside interest in owning this number one satellite video franchise in the future.

Thank you for your support and do not hesitate to email or call us with your comments and questions.


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 w