Quarterly Newsletter - 1st Quarter, 2013
PERIOD FMR* Taxable FMR* Retirement S&P 500 DOW Russell 2000
1st Qtr +11.98% +6.50% +10.61% +11.92% +12.03%

The U.S. stock market hit record highs (S&P 500: 1569 and Dow Jones: 14,585) in the last week of March to end the first quarter. The S&P 500 was up 10.06% in virtually a straight line since the end of the year notwithstanding: the fiscal cliff, significant tax increases, extreme political dysfunction, sequestration, no Federal budget, continuing budget resolutions, $17 trillion in debt, and last but not least, the insolvency and shut down of Cyprus's banking system. This quiet rally in the Standard & Poor's 500 stock index is the eighth-longest in history, starting March 9th, 2009. Five Mile River accounts were +11.98% and +6.50%, taxable and qualified accounts respectively, in the first quarter.

A natural follow-on question for all investors might be: WHY such a quick impressive run in the first quarter? An even better question would be: What can I earn for the rest of the year starting April 1st? We will try to answer both questions and then provide some detail on one of our holdings that is representative of how we have positioned your portfolios to navigate both the negative noise and our goals of preserving and growing your capital in a volatile environment.

First, question number one: Why such a positive first quarter? Our continuing fiscal dysfunction forecast at year end was flat to +8% for 2013, with a fiscal functional forecast of 1760 (16x $110) or +23% from year end 2012. The latter seemed like an unrealistic goal at the beginning of the year, and although the probability of this big upside is not better than 1 in 4, it is still a possibility but it is too soon to tell. Extrapolating the first quarter performance into the remaining three quarters of the year is probably unwise, but for now, we have three positive factors at work supporting a higher equity return than our previous upside of 8% for 2013. We are cautiously optimistic because:

1. There has been a short-term stand-off or truce among the President, the Senate and the House. How long this calm can last is anyone's guess, but there is a small window of compromise to work on our debt, deficits, entitlement reform, and immigration reform before the inevitable resumption of full scale political combat over the 2014 mid-term elections. A quick return to partisan bickering and full time political campaigning this Fall would likely cap the market's upside at significantly less than our optimistic functional forecast of 1760 for the S&P 500.
2. Economic growth most likely accelerated in the first quarter from the depressed 0.4% fourth quarter GDP (the economy froze up from fear of fiscal cliff) to an estimated increase of 2.5% to 3.5% in the first quarter. Nevertheless, the U.S. economy is still stumbling in fits and starts, most likely in a 1% to 2% GDP growth range. Personal income is down, and long-term unemployment is stubbornly high. We are not likely to accelerate growth unless fiscal sanity is addressed with concrete actions to bring us toward a balanced budget within ten years. While earnings are still growing for most sectors (+5% to +7% in 2013), sales growth is slowing with few exceptions (Europe in recession and China slowing are impediments), and corporate profitability peaked in the second quarter of 2012 with margins flattening or decelerating. Stock market valuations for many companies are still fairly valued but this stock market is not being driven by fundamentals now, but by the Federal Reserve's unsustainable zero interest rate policy.
3. Finally, and most important, the Federal Reserve is printing future money by buying $85 billion dollars of government and mortgage backed debt every month. The FED is doing this to keep short-term interest rates near zero and holding interest rates down on longer maturity debt to stimulate employment. Without the FED intervention, normalized interest rates on government debt would be double what they are right now. While this quantitative easing (called QE3 or QE4) has certainly helped housing and automobile employment recover nicely, its effect on broadly increasing employment to reach its current target of 6.5% is at best problematical. How long the FED will keep buying up our Federal debt is the current key question for financial markets, but a question without a solid answer. The FED is in uncharted waters without precedent.
The principal effect of the FED's easy monetary policy has been to stimulate investors to switch out of their money market and fixed income bond holdings and into stocks to earn a real return on their investment portfolios. THIS SWITCH HAS BEEN SIGNIFICANT IN THE FIRST QUARTER. Barclays U.S. Aggregate Bond Index declined 0.12% in the first quarter for the first time since 2006. The 10-year Treasury Note yield at 1.8% is now negative after projecting inflation at 2% to 2.5% (however, as most consumers know, the cost of rent, food and healthcare is rising at significantly more than 2%). Typically, stocks produce positive returns when bond yields are negative and expected long-term stock returns of +6% to +8% are a reasonable forecast. Compounding your money at this rate is both a realistic and a significant outcome which preserves and grows your capital with inflation at 2% to 2.5%.

All kinds of investors, institutional and individual alike, are asking themselves whether the almost certain risk of losing purchasing power with their cash and bond holdings when the FED ends quantitative easing calls for a change in their cash/bond allocation. Many large sophisticated institutional pension and endowment funds have been wrong and underweighted in U.S. equities during the doubling of our stock market from the bottom in 2009. The result is that the shift to equities for higher real returns and acceptance of increased short-term volatility is underway and favorably impacting equity returns. Even investors looking for income earn a higher return from the dividend yield on the S&P 500 index fund than they do owning a 10-year Treasury Note.

This last sentence is not a very subtle way to come back to our focus for Five Mile River portfolios, namely reliable and growing DIVIDENDS. Tax rates were finally set in stone at the very last moment in the 2012 fiscal cliff compromise, so capital gains and dividend tax rates are the same. Our strategy continues to focus on companies with high-quality defensible business models, strong balance sheets with free cash flow, and trustworthy management teams who have a strong incentive to create shareholder value from rising dividends and stock buybacks. One of those franchises and current portfolio holdings is the well known company Johnson & Johnson.

Johnson & Johnson (JNJ)

JNJ is one of only six companies in the S&P 100 that is AAA rated with 29 years of earnings increases and 50 consecutive years of dividend increases. JNJ is the world's most diversified manufacturer of healthcare products and provider of services, for consumer, pharmaceutical, medical devices and diagnostics. In addition to very familiar products such as Tylenol, Aveeno, Band-Aid, Neutrogena, Johnson's baby products, JNJ also manufactures DePuy/Synthes orthopedics and Vistakon disposable contact lenses. Other products and services include LifeScan blood glucose monitoring and insulin delivery, Ortho-Clinical Diagnostic serving the blood transfusion community, cardiovascular care, surgical and infection prevention products, dermatology products, contraceptive products, diabetic and gastrointestinal pharmaceuticals. Worldwide sales are $67 billion with forecast sales growth of 4% to 5% and earnings growth of 7% to 9%. Valuation is reasonable at 15x this year's earnings estimate of $5.40 and the stock yields 3% (JNJ's bonds yield 1.8%, the same as the10-year Treasury Note). The new CEO as of one year ago, Alex Gorsky, has made solid progress in turning around the challenges faced in their consumer products manufacturing segment. He is committed to continuing JNJ's dividend growth record and to improving the profitability and growth profile of their huge healthcare franchise. Our 12-18 month price target is $92/sh, which would provide a total return including dividends of 15%.

We value your support and welcome all questions and comments, both positive and negative at any time. Five Mile River continues to welcome new individual clients, as well as, larger family accounts and appreciate your referrals.


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.