PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +4.65% +7.09% +12.58% +20.96% +12.06%

After a flat stock market in 2011, the first quarter surprised most investors with a 12% gain (S&P 500), the best quarterly start to a new year since 1998. The S&P 500 closed March at 1408 versus the year end close of 1257, virtually an uninterrupted climb for three straight months. The Dow Jones Industrial Average gained 8% and is within 7% of the all-time high. The technology weighted NASDAQ rose almost 19%, dominated by the huge rise in Apple Computer. Five Mile River taxable and qualified (IRA, pension) portfolios were +4% to +7% in the first quarter. The best performing sectors were healthcare, technology, manufacturing and banking, with smaller companies outperforming larger companies as investors felt better about taking on more risk.

Our S&P 500 market forecast for 2012 is the same as our market forecast for 2011, namely 1350-1425, which translates to a growth of 9% to 15%. So where does this leave our forecast and the stock market for the rest of the year? With our upside forecast for the S&P at 1425 and the quarter close at 1408, we believe most of the gain for the year has been achieved in the first quarter. The absence of new negative reasons to sell in the first quarter let the market rise to reflect last year’s higher corporate profits. There was little motivation for investors to sell as our easy money policy continued with low interest rates, positive employment numbers, and the proverbial “can kicked down the road” in Greece.

Not unlike last year’s quick market run up in the first quarter, our comment was “not so fast,” as there were several political and economic “event risks” ahead that we thought would create volatility. Last year these events did occur, creating significant market volatility and the market finished flat on the year. Dividends provided the performance difference for FMR and we continue to execute our total return dividend growth strategy in your portfolios.

We view the first quarter rally as a quick validation of last year’s strong profits with the market still reasonably valued. We will stick with our positive market forecast of +9% to +15% for the year and do not expect this torrid first quarter advance to be sustainable.

The “event risk” possibilities from now until November are considerable. The U.S. is not likely to be able to decouple from a recession in Europe as our corporate profitability will be slowed from weaker export growth. China, India, and Brazil are all slowing significantly. The U.S. recovery from the Great Recession has been, and continues to be sub-par with growth only in the 2%-3% range. Corporate profits will be modestly higher this year (+5%) but profit margins likely peaked for most sectors in 2011. This is not catastrophic as stock market valuations are reasonable, but quarter to quarter profit gains will not be as strong a catalyst in the face of many unresolved international and domestic fiscal issues.Not unlike 2011, volatility and uncertainty for the markets is likely to come from both old and new issues:

1. The risk of further debt contagion in Europe is still high. Spanish private debt is 220% of GDP and their housing bubble was bigger than the housing bubble     in the U.S. Spain’s economy is huge compared to Greece and Portugal.
2. Israel, Iran’s nuclear program, Middle East unrest in: the Straits of Hormuz, Syria, Egypt, and Iraq continue to be issues.
3. North Korea.
4. The Supreme Court’s decision in June on The Patient Protection and Affordable Care Act (PPACA).
5. The $1 trillion dollar tax increase across the board (largest in U.S. history) scheduled to be implemented on January 1, 2013. Attention to this tax bomb
    will affect business investment, consumer spending and investor sentiment.
6. The end of the debt super-cycle: how does the U.S. solve the $1 trillion dollar annual federal budget deficit as far as the eye can see.
7. The Presidential Election: we have commented before that the partisanship dividing the country is counterproductive to finding real solutions to deficits
    and reform of our entitlement programs. The rancor is likely to get worse over the next seven months, but we encourage you to stay focused on the
    facts and not the rhetoric. Every presidential election is important, but the stakes for the U.S. economy are much higher than normal in 2012.

Too much too fast in either direction is not easy.

As we have discussed in some of our past letters, when psychological stress and emotion are at their peak, it can impair our cognitive skills and lead to just plain bad decision-making. These moments can push all of us towards uniform mass conformity or wishful thinking to reduce our anxiety. It can and does happen to all kinds of investors in both big unexpected stock market rallies, as well as, the tortuous 15%-20% corrections of 2011. Sudden strategy changes outside your normal investment framework or “comfort zone” typically lead to damage to your financial health.

Our core fundamental strategy of following a diversified dividend-oriented approach for our long-term investors remains firmly intact. We all know that current record low short-term and long-term interest rates do not come close to offsetting the purchasing-power risk that is inherent in owning U.S. government debt, even if you believe inflation is only 2%-3%! We do not! Everyday consumer prices for food, fuel and healthcare are sky-rocketing, so we believe inflation is more like 6%-8% than the reported CPI number of 3%.

The best way to live and sleep through the current and expected market turmoil is to stick with a disciplined strategic plan of investing in companies with dominant competitive market positions that pay growing dividends. There is and has been comfort through the volatility of the past few years in knowing these dividends provide a stable and growing cash flow that can support current needs as well as be reinvested to create long-term wealth. Government bonds do NOT do that and should be considered lethal to your wealth at the present moment.

The looming threat of the administration’s enormous tax bomb, including their proposed dividend and capital gains tax increases, does not significantly alter our investment strategy for long-term investors. The overall stock market could pause or correct as Congress argues whether more taxes create growth and solve the deficit problem. There are two reasons why dividend paying stocks should continue to perform well for the long-term. First, about half of all common stocks are held in tax-deferred accounts such as IRA’s and pension funds where dividends are not taxed. And second, the largest number of taxable accounts that hold dividend stocks are owned by Americans who simply do not have the ability to receive growing income elsewhere.

Despite our laundry list of what could “go bump in the night,” the future for the U.S. is brighter than for either Europe or China. This is because we are more likely to solve our seemingly intractable problems sooner, as American voters discern facts from fiction in how economic growth and jobs are created. In Europe, it is now more obvious than ever that larger government, more taxes, more debt, and more government regulations do not create jobs or prosperity. This approach does not work in Europe (and will not work in the U.S. either). Restrictive labor laws reduce competitiveness and productivity and with the exception of Germany, who made reforms early, the workout timeframe for most of southern Europe is dishearteningly long.

Europe’s population will shrink by as much as 100 million people by 2050 as declining birthrates and rising sentiment against immigration will work against a growth agenda. China, while growing much faster than most of the world over the past decade, will also experience a decline in the working population as a result of its one-child policy. There will be an estimated 250 million Chinese over 65 by 2030! This enormous demographic trend makes our entitlement reform issues of pensions and healthcare look almost manageable, and they are, with bold and enlightened leadership.

In stark contrast, the U.S. population will grow from 310 million today to about 420 million by 2050 and our workforce (think productivity and new manufacturing jobs) will grow by almost 40%, while China’s and Europe’s will shrink. Moreover, the U.S. has the reserves and the capability of moving towards energy self-sufficiency with the development of abundant onshore shale oil and gas reserves. Manufacturing jobs will come back to the U.S. as higher land and wage costs emerge in China. The U.S. will continue to lead in both technological innovation and research and development in the pharmaceutical sector. Our banking industry’s balance sheets have been repaired, and we now have some of the strongest corporate balance sheets in the world. Finally, we have “green shoots” of a housing recovery appearing in many regions of the country as excess homes are being rapidly absorbed and new housing starts are significantly below household formations. Home affordability is at a record level versus renting.

The coalescence of these positive factors should support current stock market valuations and could provide the base for a return to the higher historic equity returns of 10% per year after the past lost decade of zero return from common stocks. Absent an avalanche of bipartisan cooperation between now and the Fall elections, further substantial market gains are not likely. For the stock market to make substantial progress, the impending tax bomb of 2013 will need to be defused and major bipartisan fiscal reform enacted in 2013-2014. As unlikely as it may sound to be optimistic about these policy steps occurring, we believe our dividend portfolio strategy is the correct path to protect and grow your assets.

We thank you for your continued support and faith in our investment team and strategy, and we welcome your questions and comments at any time.

Sincerely,

Lee Todd Martha


*The performance information above *  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.