PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +6.40% +3.78% +5.39% +5.27% +8.51%
What a difference one year makes. One year ago the U.S. economy was sixteen months into the longest recession of modern times. The stock market made what is likely to have been a generational low on March 9, 2009 with the S&P 500 touching 676. As the 2010 first quarter ended, this broad index hit 1169, up 72% in just a little over one year (55 weeks). We said a year ago that markets always bottom out when the media headlines reflect the worst news as they are telling us what has happened yesterday, not what will happen in the future. So one year ago, headlines cited terrible unemployment numbers, falling housing values, and a diminished consumer: all lagging indicators. One year ago the 10-year annualized return for the stock market was an incredible -2.6% (S&P), and we commented that this was so far below normal and that regression to the mean (positive returns) was a much higher probability than further declines. The perceived risks for buying common stocks a year ago seemed to be too high at the time but, in fact, the risks were low.

Why did this record bear market turn into the second most powerful bull market rally, and what is the fundamental evidence today that it is sustainable?

While oversimplified, bear markets have always been followed by bull markets. But how did this negative sentiment turn around so quickly from such pervasive pessimism? Huge market rallies from the depths of despair almost always “climb a wall of worry” as investors are generally in disbelief that anything can go right, and even optimistic investors are typically surprised by the strength. Finally, small investors who have been hit hard gradually begin to tiptoe back into the market a year or more after the bottom, when the alternative of earning almost zero returns on their cash begins to not look very competitive with equities. So this has been the strongest rally going back to 1960, with the previous record +62% in 1983. Previous rallies have been proportional to the pace of economic recovery and 1983 was strong. Let’s briefly review the underpinnings of this rally and recovery.

At first, the Federal Reserve’s policy actions stopped the hemorrhaging and saved our financial system from “freeze up.” The Treasury injected capital into banks’ balance sheets and the Federal Reserve injected massive liquidity in our financial system by purchasing over one trillion dollars worth of debt. The bond markets began to function again as corporations were able to refinance their debt and issue new debt. Confidence in consumer’s bank deposits and money market funds was restored. Our biggest banks were subject to “stress tests” to prove their viability. Then the equity markets allowed firms to raise new equity, and to strengthen their balance sheets. Most of our largest corporations had very strong balance sheets at the beginning of this recession, so confidence began to return more quickly to those firms.

Since this recession was worse than any of our recent downturns, the rebound in percentage terms is likely to be strong. We expect strong economic activity to originate primarily from two areas: inventory rebuilding and exports. Corporations cut costs dramatically in 2008-2009, paring inventories so low that many soon found they did not have enough products to meet demand. Inventories are still low. Export demand held up stronger than anticipated by many firms as the emerging countries did not have a U.S. style financial crisis and meltdown. Canada, for example, had no “sub-prime” led financial crisis and its’ banks are strong. Furthermore, emerging market economies account for 35% of world GDP with 87% of the world population. China’s economy has been growing at 10% and emerging countries such as Brazil, India, Korea and Australia are growing almost as fast. U.S exports in the last six months have been surging, up 36%! Most of our large cap, quality companies are beneficiaries of emerging market growth with 40%-50% of their sales abroad.

Evidence that inventory rebuilding and export growth are both helping the economy is shown in the manufacturing purchasing mangers’ index which hit a six month high in the 2010 first quarter. Industrial production has increased at an annual rate of 10% over the first eight months of this recovery. This is also a record when compared to previous recoveries! This measure incorporates semiconductor equipment, autos, machine tools, steel, rigs, heavy trucks and railcar loadings. The U.S. recovery appears well under way with retail sales up 3% in the first quarter, and payrolls are beginning to increase. Real consumer spending hit a new pre-crisis high in the first quarter. Finally, corporate profits are likely to make a new high this year, four years after their prior peak in 2007.

So what does this dramatic change in sentiment, market place dynamics, and the stock market portend for the future; and what about all the negatives we still read about in the U.S. economy?

In the 2009 Five Mile River year end letter (January 21, 2010) we said that there was appreciation potential of 6% to 13% in the market for 2010 which would be roughly 15x-16x S&P 500 estimated earnings number of $80. With the stock market up about 5% in the first quarter, this estimate is still within a reasonable range for a 2010 year end outcome. We have not raised our expected range because the U.S. economy faces some potentially difficult headwinds from both old problems still to be resolved, and new challenges that lie ahead. Significant progress in dealing with these issues could provide further upside of an additional 20% into 2011 on even higher corporate profits of $90-$95 for the S&P 500.

What are these headwinds from old problems and new challenges?

The old problems still to be resolved include the continuing acceleration of housing foreclosures; commercial real estate that may be bottoming but overvalued properties may have to be refinanced; and the unpalatable high levels of unemployment. Our view has been that the general housing market would hit bottom in the Spring of 2010, varying of course by individual states and cities with a very slow recovery that would take at least five years (2015) to return to the peak prices of 2006. In the commercial real estate market, prices have stabilized or are rising in certain property sectors. High levels of structural unemployment are expected to continue for sometime and not return to the “normal” 5% level for as along as five years. The reasons are twofold: first, we are going to produce more “stuff” with fewer employees in every business by improving productivity with both existing resources and new technology (such as IBM and Oracle). Secondly, the rising burden of new federal, state, local, healthcare and energy taxes will keep many small and mid-size companies cautious for a much longer time than what we would normally experience in a standard recovery.

Under new challenges for the economy, we would include the unsustainable and growing government deficit; rising interest rates; and the specter of future inflation. At some point bond buyers are not going to loan the U.S. money at today’s low interest rates without fiscal discipline. Clearly something has to change. The spending choices that our government makes will temper economic growth. Government spending matters because an economy’s debt level can have a negative impact on economic growth if it is excessive. The Federal Government’s spending spree will necessarily cause taxes and borrowings to rise, further stunting future economic growth. The second challenge is the delicate process of the Federal Reserve withdrawing liquidity from our economy as its rescue programs wind down, and they raise short-term interest rates from zero. It is important to point out though, that if this process is smooth and done well, then it likely will not become a near term negative in a recovering economy or a reasonably valued stock market. Lastly, rising inflation could result from the Federal Reserve printing too much money. Since everyone is watching the FED for such an imprudent development, it is unlikely to take place without a heated public debate. With ample spare manufacturing capacity and large numbers of unemployed in the labor pool, the specter of serious inflation is not a concern for this year, but bears watching down the road in 2012-2013.

Going forward from here…..

So we remain conservatively optimistic in our FMR portfolios with cash reserves generally under 10%, emphasizing companies that pay and increase their dividends regularly, have strong free cash flow, great balance sheets, and large moats around their business models. Furthermore, we like managements that own big positions in their own stock, who run their business model to maximize future earnings, and thus, shareholder value. At the bottom, in the worst of this Great Recession and bear market, we talked about the intrinsic value of our large technology holding in IBM. We said that their business model was focused on solutions, services, and software. Their earning power from using technology to improve productivity for all kinds of businesses and institutions was at least $10.00 a share. They earned $10.05 despite the recession. At the time, the stock priced at $80 (its low was $72), it was a clear buy and we added more to our accounts. Today IBM is $128, up 77% from its low, as the management continues to execute their business model through the worst recession of the modern era. Today we see earning power of at least $12.00 per share for IBM by 2012 and fair valuation of $145-$150 within twelve months, or +15%. Since we believe strongly that corporation’s capital spending in technology will significantly help power this nascent recovery, we added another dominant technology business model to our portfolios in the first quarter, the Oracle Corporation. Oracle develops, markets, and distributes database and middleware software. Additionally, it provides applications software that helps companies manage their business. Foreign sales are 55% and a recent acquisition of Sun Microsystems, a computer maker, offers unrecognized opportunities for Oracle’s revenue growth and earning power. We believe that Oracle’s enhanced three year earning potential is at least $2.50 a share with a $40 target price and 60% upside appreciation potential. Oracle fits the profile of what we are looking for in what should be a more selective stock market than 2009.

We would like to thank you for your continuing support and always welcome your comments, questions and emails at any time. We will be calling you over the next couple of weeks to discuss your investment goals, but please do not hesitate to call us at any time to discuss your account progress and goals.


Lee Todd