Taxable Estimated
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr +8.03% +4.62 % +5.92% +7.06% +7.64%
2nd Qtr -0.40% -1.11% +0.09% +1.41% -1.91%
YTD +7.34% +3.69% +6.01% +8.57% +5.59%
Our watch words at the end of an exuberant first quarter stock market performance of +6% were “not so fast.” We reported then that stock prices had almost doubled from their March 2009 low and looked fairly valued and due for a breather. For 2011 the S&P 500 was 1332 on March 31st and finished at 1320 on June 30th, virtually flat for the quarter. While all investors enjoy rising markets, the current environment strongly reminds us of why we like companies with free cash flow that is shared with their stockholders as growing dividends. Dividend paying stocks have a much better chance of preserving the purchasing power of our capital than government bonds.

Given the incessant daily noise of Greece contagion, deficits, debt ceilings and inflation, coupled with fairly valued stocks, the flat quarter was not surprising. Our upside target remains between 1350 to 1425 for the year (an increase of 2.27% to 7.95% from 1320 at the end of June). The challenge for significant upside to this range will hopefully come into focus with some real slowing in the growth of government spending (Note: the phrase “spending cuts” does not mean real cuts in spending for 2012, it actually means spending grows at a slower rate but still goes up!). The national debt ceiling limit deadline of August 2nd does not mean that the U.S. Government will begin defaulting on its interest payments on that date. The political rhetoric between the two parties is disheartening at best, and will continue to dominate the media and confuse the public all the way to November 2012. Until that time, we continue to favor the 3%-5% yields available on high payout stocks that offer a real return because of their ability to raise dividends along with inflation. High yielding stocks routinely outperform low and no yield stocks by nearly 3% per year.

The Five Mile River taxable and IRA portfolios performed in line with this flat second quarter with higher dividends (from Master Limited Partnerships) in the taxable portfolios providing them a slight performance advantage. We also continue to add commodity producers (gold, coal, iron ore, copper, potash) as a hedge against future inflation. Together these commodities represent approximately 10% weighting in most FMR portfolios.

What do we see from the current economic tea leaves?

Second quarter GDP (gross domestic product) is very likely to show another quarter of sub par growth in the 1.5% to 2.0% range following a weak first quarter. The Japanese tsunami and earthquake definitely caused a major negative impact on manufacturing. The auto sector was the most severely affected. We expect only a modest reversal of that impact this summer which should help third quarter GDP growth back to the 2.0% to 2.5% range. This level of growth, while better than the first half, is not sufficient to reverse this jobless recovery. We will address this more specifically in the next section.

Concerns that the problems in Greece will spread globally are being discussed throughout the news. Importantly, Greece is only 2.5% of the European market, but the larger concern is over possible contagion to other weak countries, i.e., Italy and Spain, and the weak capital positions of the European banks.

Our Jobless Recovery

One of the most important indicators to watch over the next quarter will be unemployment claims, which have been stubbornly running above 400,000 a month (this number needs to be permanently fewer than 400,000 to be even neutral). As we have discussed in prior letters it is private employment and not public employment that creates higher GDP growth in our economy. Jobs and our deficit are the two key factors that will define our future and dominate the 2012 political cycle. The manner in which we resolve our debt and spending problems will be the defining issue of this decade.

We have a labor force of about 153 million people of whom 14 million are officially unemployed (not working and actively seeking a job). We also have at least another 8 million people who are underemployed (part time or given up looking). That leaves about 131 million actually working. By the old definition of 5% as full employment, we should have only 7.7 million unemployed workers. However, this is not a static exercise as job creation is a moving target. Each year we have to add another 2 million workers to the labor force to accommodate new workers from population growth, immigration and the re-entry of discouraged workers. The math is very difficult because we would need 460,000 monthly job gains to hit full employment by the end of 2012. Unfortunately, that level of job gains is not even remotely realistic at this time. Even at a seemingly impossible 250,000 per month job gains, full employment would not be reached until 2018. So as you listen to the speeches and look at the monthly jobs numbers, put them in the context of the above reality. So what happened to our jobs and our economic growth that we have such a huge employment problem?

Too much debt and structural deficits

As most of you now know that are watching the current debt ceiling crisis unfold, the U.S. has over $14 trillion of debt, rising at an average of $1.3 trillion a year. The deficit spending of the last three years has simply not produced new growth nor new jobs. Thirty years of runaway borrowing at almost every level of government has created a horrifying oversupply of paper assets. While the absolute number is enormous, it is not the number itself that is the problem, it is the relentless direction up, and the country’s ratio of debt to GDP that are the crucial factors. When that ratio rises above 90 percent, there is a reduction of at least 1% in our economy’s growth. This comes primarily from the cost of the public debt crowding out productive private investment (Greece is an example of government crowding out the private sector). The U.S. is on an almost certain path to a debt level of 100% of GDP in just a few years (including state and local debt) unless major bipartisan reductions in spending or tax increases are agreed upon. The basic problem with calling for more tax increases to fund deficits and government spending is simply this: TAX INCREASES REDUCE GDP BY ANYWHERE FROM 1 TO 3 TIMES THE TAX INCREASE. There are only two ways to grow our economy: 1) You can increase the working-age population or 2) You can increase productivity. That is it, no other secrets. Government spending and hiring does not increase productivity; but for example, Google spending and hiring does and then some! Going back to our forecast, GDP growth rates at levels anywhere from 2.0% to 3.0% for the U.S., does not get us back to full employment. We need the economy to grow at 4%+ for an extended period to stabilize and bring down our unemployment problem.

Our overspending and debt problems only add to the uncertainty for both consumers and businesses as to how to plan and invest for the future. Small and medium size businesses create 90% of net new jobs in America and these job creators are extremely cautious on investing and hiring because they do not know whether they are going to have much higher medical insurance costs, more costly regulation, or more taxes (or all of the above). Over 50% of small/medium business owners file their company’s taxes as sole proprietors or limited liability corporations (LLC) which are taxed at the personal income tax rates, not the corporate tax rate. So as the partisan rhetoric fills the airways, it is worthwhile to remember who actually creates the jobs that every politician agrees is their number one priority. The highest probability outcome is a stalemate right up to and possibly beyond August 2nd. Frankly, given that the political contest is now in full swing, we expect only a modest short-term deal, trading off apparent spending reductions with a debt ceiling increase to get us through the 2012 elections. Any serious agreement beyond the minimum would be a major surprise to the stock market in a very immediate and positive direction.

A look at a new addition to our FMR portfolios: McCormick & Company (MKC)

A recent addition to our portfolio is another company with identifiable and sustainable advantages with strong brands that make it hard for competitors to replicate. While this kind of company may seem boring, cash from reliable businesses that write checks to their shareholders year after year are very attractive in an uncertain and volatile environment. Most of your FMR stock holdings pay dividends at a higher yield than government bonds and more than keep pace with inflation.

McCormick & Company fits this profile as it controls more than half of the market for spices, seasonings, and flavorings in North America and is more than twice the size of its next largest competitor. Market share and pricing power are steady and excellent with leading brands such as McCormick, Lawry’s and Old Bay. An A+ credit rating with modest debt, strong free cash flow and 25 consecutive years of higher dividends for shareholders support a payout ratio target of 35%-45%. The dividend growth rate has averaged over 10% for the past ten years and should continue at that rate in the future. The company’s strong reputation for quality and innovation in new products that are recession resistant makes for a “no drama” holding with 10% one year upside and a 2%+ dividend growing at 10% a year.

As the summer’s economic drama unfolds over the next several weeks we would be glad to field your calls and emails on what we see developing in Washington. Thank you for your confidence and support.


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. Fourth quarter and YTD approximate performance ranges are due to the conversion to Royal Bank of Canada (RBC) in June. Individual performance reporting will be available shortly from RBC.

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.