PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +6.40% +3.78% +5.38% +5.27% +8.51%
2nd Qtr 0.0% to -2.0% -2.0% to -4.0% -6.64% -6.51% -10.19%
3rd Qtr +8.5% to +10.1% +8.6% to +10.0% +11.30% +14.89% +10.94%
YTD +6.2% to +10.4% +4.4% to +5.7% +3.91% +7.40% +8.11%

In the third quarter the stock market began in a state of worry and ended with a note of optimism, posting the best September in 71 years at +8.9% for the S&P 500. In our second quarter letter, we said that the stock market was, at that point, attractively priced after a down second quarter. We stated that the market had the potential for an upside of +12% to +20% for the remainder of the year, yielding a forecast range of total return for 2010 of +6% to +13% by year end. With the S&P 500 closing out the quarter at 1141, our year end target projection of 1200 for this index remains the same (15x $80 of earnings). FMR's conservatively invested portfolios bounced back nicely in the quarter and are now up for the year. As you are aware, we continue to focus on dividend-paying stocks for the great majority of our positions.

Why the sudden enthusiasm for stocks in September? Is it sustainable?

July and August despair focused on the probability of a double-dip recession. But two significant announcements emerged from the gloom. First and more important, Fed Chairman Bernanke said that "inflation is currently at levels below those judged to be most consistent with the mandate to promote maximum employment and price stability." In non-Fed words Bernanke meant that he is prepared to try another round of quantitative easing because the economy remains weak and inflation is low. The stock market took this to mean that the Fed does not care about the value of the dollar which continued to decline against just about every other currency. Therefore, it was interpreted to mean investors might get out of the dollar, and instead own assets such as bonds, stocks, and commodities. The second announcement was on September 20th, when the NBER (National Bureau of Economic Research) declared that the recession was over. They said that the recession that started in December 2007 ended in June 2009. While this means there cannot be a double-dip recession, this technical end of the recession means little to the 17% of the population that is unemployed or underemployed and to the record number of citizens on food stamps. While we understand the justification for this big September stock market bounce, we remain cautious for the remainder of the year. This is reflected in our unchanged total return expectations for 2010. We are not convinced that this sudden surge of optimism is sustainable at this current record rate of gain.

Why do we continue to be cautious?

Very simply, the outlook continues to be confusing with mixed signals and an indecisive "up-down-up" stock market. Having the Federal Reserve buy another $1 trillion of government debt on top of the $2 trillion of debt and mortgages they have already bought is unlikely to add significantly to growth, and may sow the seeds of potential future inflation. The Fed has in effect said that big government spending programs have been ineffective and therefore the only thing left for us to try is to print money and debase the currency.

Evidence suggests that the economy slowed considerably during the third quarter, to the point where +1% to +2% growth for the second half of the year seems highly probable. While the corporate profit rebound has been a tremendous support for the market rally off the bottom of March 2009, we continue to have most of the same major negatives and headwinds we have previously discussed as reasons for both caution and a defensive investment strategy. Extreme partisan politics, combined with flawed government spending and tax policies will create more than enough uncertainty over the next three months. We all know that the economy desperately needs job creation to recover. How we create the right environment to get there remains to be determined. Suffice it to say that the government has not created private sector jobs. Small to medium size businesses create jobs. In fact, without startups, there would be no net job growth in the U.S. economy. From 1977 to 2005, existing companies were job destroyers, not creators, as they lost 1 million jobs per year. Startup new businesses in their first year added on average 3 million jobs annually! Reducing the hostility towards business and the startup entrepreneurs who create the jobs would be a welcome first step to encourage job creation. To the extent that our leaders take those steps over the next few months, we would very likely boost our return expectations from the stock market.

Dividends and Gold

For our long-time clients who have heard us expound on the merits of dividends, we will be brief but consistent. We continue to emphasize companies with free cash flow who pay good dividends and grow their dividends in most years. If we can find 3% to 4% dividend yields we do not have to depend on capital appreciation for our whole total return. The dividend rally is taking place as earnings bounce back from their low in 2009. The recent mania, called the "bond bubble" by some, seems overdone as interest rates are so low today that it would take almost 500 years to double your money with a treasury bill. The 10-year Treasury Notes at 2.5% yield less than stock dividends from very high quality companies like McDonalds (MCD) or Coca Cola (KO). There is little room for error on future inflation with yields this low, especially in the face of another round of the Fed purchasing government debt. Government bond interest payments do not rise with inflation, and bonds fall in value when interest rates rise. Regular dividends from stocks can and do rise and act as cushion when stocks fall. We also continue to invest in high yielding master limited partnerships (MLP's) that own U.S. domestic energy infrastructure (pipelines, storage and processing facilities) because the have significantly outperformed the market over the past ten years.

A recent addition to our long list of quality dividend payers is the H. J. Heinz Company (HND). Heinz Ketchup and Ore-Ida potato products along with sauces, soups, pickles, baby food, baked beans and pasta is their business. Their recent 7% dividend increase with a current yield of 4% is safe and attractive for our conservative investment in the food industry, which totals 4% along with General Mills (GIS). The company's primary growth driver is in emerging markets which make up 15% of their revenues. A recent focus on China and Russia with high margin infant formula and an expanding soy sauce market in China are real positives. Heinz earnings have been predictable and not subject to big surprises

Finally, we initiated a total weighting of 4% to 5% in three different mining investments separate from our energy and coal investments. We view this weighting in mining and metals as a prudent risk diversifier whose premise is both logical and contrary for some investors. The current new high in gold and the increasing media attention does not make it a bubble in our opinion, but a hedge against the upcoming Federal Reserve's $1 trillion quantitative easing and the potential for long-term inflation. Gold is under owned by central banks, institutions, and individuals and the recent rise in price reflects the growing cynicism towards politicians, the political process, and our government's (along with most of Europe's) inability to control government spending and deficits as far as the eye can see. The enormous structural debt problems of the U.S. going forward create enough uncertainty that carving out a small portfolio weighting in metals and attractive mining stocks fits with our "insurance policy" mentality of owning real assets and sustainable business models with very "wide moats."

We purchased a 2% weighting in a gold and precious metal fund ($1.5 billion) run by Tocqueville Asset Management, a long established New York based independent equity manager formed in 1985 that specializes in finding undervalued and out-of-favor metal and mining companies. Our investment team has known the manager of this fund for over 20 years and we consider their in-depth primary research process excellent. Secondly, we purchased a 1% weighting in Freeport-McMoran Copper & Gold (FCX), predominantly a copper and gold producer in Indonesia, North America, South America and Africa. Financial strength and cash flow are excellent with some $4 billion of cash on hand and the potential and willingness to pay growing dividends to shareholders. Finally, we purchased an initial 1% weighting in the ETFS Gold Trust (SGOL), designed to reflect the day-to-day performance of the price of gold bullion, less the expenses of their respective trusts.

We truly appreciate your support and as always encourage you to contact any of us to discuss your investments. As an SEC registered company we file an ADV II form annually which is a document that describes our business. Please contact us if you would like a copy.


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.