Quarterly Newsletter - 3rd Quarter, 2012
PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr +4.65% +7.09% +12.58% +20.96% +12.06%
2nd Qtr -4.54% -5.12% -2.75% -5.06% -3.83%
3nd Qtr +7.08% +4.09% +6.35% +6.17% +4.88%
YTD +7.52% +7.18% +16.43% +19.62% +13.03%

QE3!  On September 13th  Ben Bernanke, Chairman of the Federal Reserve, announced the third tidal wave of easy money or Quantitative Easing Three (QE3) to stimulate our lethargic economy and create jobs.  This move was largely anticipated by most market participants as the stock market had been rising prior to his pledge and finished the quarter up 6.4%.  The surprise was that the Chairman promised to purchase $40 billion/month of mortgage-backed bonds (thousands of home mortgages  packaged  together in  what is called  an MBS,  mortgage-backed securities).  He also promised that the FED would keep short-term money rates near zero through the middle of 2015, nine more months than what the FED projected in August.  Unprecedented!  Clearly the Chairman and some of his fellow board members believe we have long-term structural weakness in our economy.

Will this outright monetization of debt be successful (printing money)?  The FED did not call it this, but this is the only tool it has left since short-term interest rates across the board are already repressed to record lows.  This open ended QE3 can spur the equity market as investors search for growing income.  However, feeling wealthier from higher stock prices is not the same as actually creating growth in our economy.  Productivity growth (more output per worker from innovation, new machinery, technology, and higher skill levels) is the source of a growing and prosperous economy that raises more tax revenues because more Americans are working in new jobs.

Monetary policy was effective with QE1 in getting us out of the post Lehman Brothers financial gridlock, housing meltdown, and resulting crisis.  But trying to force our economy to grow by indiscriminate printing of more money with QE2 and QE3 is another question indeed.  Despite all the liquidity created by the FED, unemployment has remained high, the post-recession recovery in our economic growth (GDP) has been the slowest in over 40 years, (1.3% in second quarter), and take home pay (household income) is growing even more slowly than the rate of official inflation (2%).  Five years after the housing bubble burst, many areas in the country appear to have put in a bottom as excess inventory has been worked down and the affordability index of buying a house versus renting is at an all time high.  Will this be enough to drive unemployment down to 5%?  Our short answer remains the same, NO, UNLESS this action is joined by serious structural reform of our government overspending that must include tax reform, entitlement reform, deficit reduction, and yes, budget cuts by the Congress and the President.

What are the unintended consequences of QE3?  Between December 2008 and June 2011, the FED pumped $2.3 trillion dollars into our banking system with QE1 and QE2.  To keep interest rates low, the Fed, as we mentioned earlier in this letter, is spending $40 billion a month to buy mortgage-backed securities for an indefinite period of time.  Because of these artificially low interest rates, the search for income by investors and retirees will accelerate.  The FED’s already bloated balance sheet will grow even larger and nobody knows exactly how they will unwind (sell) these securities when inflation rears its ugly head.  We suspect that for now they will be able to create more money than anyone expects because the economy is at a stall speed (under 2% growth), and there are over 20 million citizens unemployed or underemployed.  Broad measures of inflation are currently not signaling any problem.  Food and energy, big components of consumer spending, are volatile and currently problematic with our recent severe farmland drought and rising tensions in the oil rich Middle East.  On the other hand, domestic production of oil and natural gas is steadily rising, reducing our dependency on imports.  The dollar will weaken some against other currencies, but probably not as much as you would think because there are no other candidates for the world’s reserve currency.  However, commodities and hard assets (oil, natural gas, gold, real estate) are eventual likely beneficiaries.  We have no idea of how or when, but this monetary policy could catch up to us as the proverbial “free lunch” often disappears, just when you need one, and the medicine is even harder to swallow.  Worrying about when the FED will reduce the money supply and raise interest rates to head off the threat of inflation is an interesting exercise for economists and market pundits alike, but it is not anymore helpful in growing your capital and preserving your purchasing power than worrying about the real problems in Europe or China.
Dividend growth, real assets, stocks and bonds.  We emphasized in our last letter that the stock market’s dividend yield is higher than the 10-year U.S. Treasury Bond, something which has not happened since 1958.  And, we also discussed dividend paying companies, who can grow their dividend, that have higher future expected returns relative to 10-year Treasuries yielding 1.6%.  The valuation of stocks at 14x expected 2012 earnings is very attractive despite the slower growth of the U.S. economy.  Our forecast for the past year for the upper range of the S&P 500 in 2012 has been 1425 and we are at 1429 at the time of this letter.  The S&P 500 is now up 16.4% YTD through the first three quarters of this year, and we do not expect a significantly higher return in 2012 unless the Congress and the President undertake definitive long-term structural reform of our fiscal policy.

Serious real fiscal reform would open up the prospects for much higher stock market returns from valuations on corporate earnings (the P/E, or price/earnings ratio, rising from 14 times up to 16 times, on $110 of S&P earnings in 2013/14 equals a price target of 1760, up over 20% from today’s market level).  While this kind of upside from the current S&P level of 1429 seems like fantasyland, we should remember that when this long bear market for equities began in 2000, the price/earnings ratio was at a historic high of 28x after a decade of very good economic growth, low inflation, increasing productivity, and a technology revolution.  We are not expecting a repeat of anything like the 1990’s, but we clearly have the potential for both higher equity valuations and higher stock prices if the federal government puts its balance sheet in order.

What if the current fiscal government stalemate continues and the U.S. economy hits the “fiscal cliff” at year end?  In that unfortunate scenario, we do not want to own uncompetitive, low yielding government bonds.  We want to own and do own a balance of companies producing free cash flow that pay dividends that will grow, and hard assets that will protect purchasing power against future inflation.  Examples: In an earlier Five Mile letter we included a table that we called “free cash flow equals growing dividends” and listed six companies we own showing their 2010, 2011, and 2012 estimated dividends.  One of those companies McDonalds (MCD), paid $2.26 in 2010, $2.80 in 2011, and we estimated $3.00 for 2012.  MCD just announced that it is raising its dividend to $3.08, up 10% from the 2011 dividend.  Current yield of MCD is now 3.4%.  The growth of McDonalds dividend clearly beats U.S. government bonds, and is arguably a better credit risk and outperforms inflation.

In the category of hard assets we have significant portfolio exposure to oil and natural gas through the long-lived energy infrastructures such as pipelines and terminals in our energy master limited partnerships (Kinder Morgan Energy Partners, Magellan Midstream Partners, Enterprise Products Partners, and Williams Partners).  Yields range from 4%-6% with annual distribution growth ranging from 6%-10%.  We also have significant hard asset exposure in both the taxable and IRA accounts to real estate through REITs (real estate investment trusts) that own the underlying real estate in data centers, cell phone towers, theaters, retail shopping malls, and healthcare facilities (Digital Realty Trust, American Tower, Entertainment Properties, Macerich, Ventas).

Sitting in cash or buying government bonds today guarantees virtually no nominal return and a negative real return on your assets thanks to inflation and taxes.  Stocks are not at bargain basement prices like they were at the bottom in March 2009, but they also are not overpriced like they were in 2000.  In this real world of uncertainty, and having to make difficult choices to meet your financial objectives, we choose this balanced combination of dividend growth and inflation resistant hard assets as an effective and reliable investment strategy for producing positive long-term returns in your investment portfolios.

We thank you for your support and welcome any questions that you may have about our investment strategy or your individual portfolio holdings.


Lee                                        Todd                                        Martha                                   Colleen

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.