Quarterly Newsletter - 3rd 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%
2nd Qtr +0.43% -2.26% +2.90% +2.91% +2.73%
3rd Qtr +0.32% +0.33% +5.24% +2.12% +9.85%
YTD +12.86% +4.46% +19.79% +17.62% +26.42%

    The third quarter brought on another wave of new money into equities from both cash and fixed income. Investors expected the Federal Reserve to slow down its $85 billion a month of buying U.S. government debt as the 10-year Treasury Bond yield rose 1% (price declined) over the summer. Normal interest rate cycles bring positive equity returns when rates begin to rise as a signal that economic fundamentals are improving. However, nothing about this cycle has been normal and the FED surprised virtually every investor by deciding it would not reduce buying government debt with one week left in the quarter. The S&P 500 ended up +5.2% in the third quarter after hitting another new high on September 20, 2013 of 1729 and closing the quarter at 1681. Year to date the S&P 500 is up 19.79% as of September 30th. 

    Five Mile River portfolios consist of high-quality, high dividend paying stocks that correlate in the short-term to changes in bond prices. In the beginning of an interest rate cycle, when fixed income yields rise and bond prices go down, higher yielding stocks underperform equities. As we have mentioned in the past several quarterly letters, our most probable expected return for the year has been +8% with our best upside forecast of +23%. The latter is predicated on a successful end to the political divide over spending, deficits, and the debt ceiling this fall. This ‘Grand Bargain’ clearly seems out of reach given the small amount of time until the government runs short of cash (October 17th), particularly given the polar differences between our two parties. The selection of defensive, high dividend payout stocks in your FMR portfolios has been predicated on a slow economic expansion and a bumpier second half, as outlined in previous Five Mile letters. We expect the government to achieve a short term truce or deal allowing time to reach a longer term agreement. 

   As we watch this tragic political dysfunction unfold this fall, we continue to emphasize our high quality, dividend growth strategy and the long-term value and growth potential of these companies. Given the likely continued headwind from rates and the uncertain political environment we wanted to address in this letter our thinking as to why we maintain this portfolio strategy. 

    Firstly, we believe that interest rates will continue to rise over the next two to three years, with a normalized 10-year Treasury Bond eventually yielding 4%. Our current interest rate cycle dates from July 2012 when the yield on the 10-year Treasury “benchmark” Bond made a low of 1.43%. The yield on this bond started the year at 1.76%, hit a high of 2.92% in August, and now has settled back to 2.6% this fall. We have in all likelihood seen the low in Treasury yields for our lifetimes. With the appointment of the new Federal Reserve Chairman, Janet Yellen, a strong proponent of ‘quantitative easing,’ short-term interest rates will probably remain stable until the economy shows sufficient traction to begin ‘tapering’ of bond purchases. 

Secondly, rising rates are not uniformly bad for stocks. There have been seven interest rate cycles of rising long rates since 1992, and on average, these moves lasted nine months with rates rising 155 basis points. The average total return on the S&P 500 index during these periods of rising rates was +11%, and the market recorded a positive return in all of these periods. 

Thirdly, for higher yielding stocks, the verdict from these cycles is also consistent. In the early stages of a rising rate environment, portfolios containing a defensive positioning with yield oriented names do underperform the broad growth indices. In these early stages, traders instead gravitate to small companies, momentum growth stocks, and cyclical businesses because people interpret the rising rate environment as indicative of a stronger economy, which is traditionally the case. In this rate cycle, rates are rising because the Federal Reserve will have to dial back on the fire hose of liquidity it has been injecting into the financial system. Therefore less accommodation, not a stronger economy, is the reason for the rise in rates. It is our belief that we could start to see a better economy but that hope is still a ways off from realization, and requires some real fiscal reform. Given the appointment of Janet Yellen as Bernanke’s successor, it is quite likely that we will see Federal Reserve policy continue to provide liquidity to keep the economy improving albeit at only a slow rate of growth.This scenario argues for exactly the portfolio structure we employ, one that will reduce volatility, and enhance ‘slow growth’ returns with attractive dividend yields and growth. 

In just the last few weeks the markets have been buffeted by two significant, and to some degree, unanticipated events. The Chairman of the Federal Reserve, Ben Bernanke, shocked the financial world on September 18th with his decision to keep “Quantitative Easing” going full out, instead of reducing their monthly bond purchases by $10 to $15 billion. (They have been buying $85 billion of government debt a month in the context of a $3.5 trillion balance sheet in what is called quantitative easing or QE). He had spent four months setting up the market for reduced bond buying (called tapering to make it sound less ominous), then “pulled the rug out” or the football away from the kicker at the last moment. His term as Chairman of the FED expires on January 31, 2014. Yes, Bernanke’s credibility is severely damaged and at some point the Federal Reserve, soon to be chaired by Jane Yellen, will have to unwind the $3+ trillion of government and mortgage bonds it has purchased, starting interest rates on the path back to normalization. 

The second event was the government shutdown on October 1, 2013. The political divisiveness that had been building for the past five years had reached a crescendo the first week of October. While this has been truly frustrating to watch, the bigger ‘event’ is whether our government will permit a possible default on the interest payments due on the debt it has issued, or Medicare and social security payments that are all very lumpy, in just the next several weeks. Speculation about a possible default has consumed the media and has added to the pressure on markets, worldwide. As most observers of this national embarrassment know, the real issue will be raising the DEBT CEILING which has a preliminary deadline on October 17. The Treasury will reportedly be down to its last $30 billion of our cash to pay the bills as of that date. Government revenues cover about two thirds of the cash needed to fund all spending programs and interest on the $17 trillion of federal debt. Despite the shrill outcry of doom and disaster from the self-interested political class, a debt default is unlikely, and the Treasury has many options in prioritizing the $200 billion of our cash that pours into the government every month. 

   We believe Congress will reach an eleventh hour agreement preventing default. There will be no default. We see two probable (?) outcomes to this fiscal juggernaut. A ‘Grand Bargain’ will come later and take longer if it is to be a reality. If a comprehensive negotiation to most of the big issues is the eventual outcome, then the significant upside forecast for the stock market is realizable with accelerating economic growth and lower unemployment. Alternatively, the higher probability outcome will be a short term compromise to sit down later and discuss the big fiscal issues. If the latter does occur, then the slow growth, high unemployment model we have been living with for the past several years will grind on to the 2014 midterm congressional elections. We hope for the former outcome but have structured our portfolios for the latter. Managing our friends’ and families’ assets prudently is not based on hope.  

   Finally, a normal interest rate cycle comes about because of a faster underlying healthy growth in the economy (real GDP) and moderately rising inflation. But in this cycle, we have NEITHER! The economy has been stuck at 2% or less growth for several years because of poor fiscal policies while core inflation has actually been declining. We have structured your portfolios to endure “black swan” events with less downside volatility. Our long-term return expectations remain unchanged and should range between yearly returns of +8% to +10% over the next three to five years, with a big component of that return coming from growing cash dividends to shareholders. This rate of growth doubles your money in approximately eight years. The majority of companies in our portfolios generate a cash yield of 3% to 5%, whose dividends are forecast to grow at 5% to 6% per year. Your companies were selected because they have strong balance sheets, strong free cash flow, and access to capital, proven shareholder friendly management, and flexibility to withstand both interest rate cycles and “black swan” events.  

    Thank you for your business and support for our team. We encourage any and all questions and comments about the market, individual companies, your portfolio structure and objectives at any time. As this fall is likely to be a volatile news cycle focused on our government’s actions or inaction, we will send out interim email blasts as needed on their significance to you as a long-term investor.


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.