PERIOD FMR*
Taxable Estimated
FMR*
Retirement Estimated
S&P 500 NASDAQ 100 Russell 2000
1st Qtr 4.67% 2.56% 0.70% 1.02% 1.95%
2nd Qtr 3.63% 1.31% 6.26% 9.13% 4.12%
3rd Qtr (3.34%) 1.52% 3.74% 8.12% (3.99%)
4th Qtr (0.32)% (2.22)% (3.33)% (0.30)% (1.89)%
YTD 4.48% 3.11% 5.46% 18.67% (2.75)%

The year 2007 finally drew to a close with what has been an exhausting and volatile year for the financial markets with the S&P 500 at -3.3% for the fourth quarter and finishing +5.5% for the year. Both taxable and retirement portfolios were up in FMR at +4.48% and +3.11% respectively for the year, modestly lower than the S&P 500. Fourth quarter performance for both types of accounts was down to a lesser degree than the S&P 500 as our energy and utility holdings performed better as did the few large cap growth stocks we have added over the course of the year.A year ago at this time we had just come off a solid +15% year and forecast that we thought 10%-15% was possible for 2007 even though it was likely that volatility would increase dramatically. We projected that any positive performance would have to come in the second half of the year. However, macro forecasting is always a dangerous activity at best and 2007 proved no exception. The exact opposite of our forecast occurred with positive performance in the first half of the year and flat or zero performance in the second half. Given the severity of the unfolding credit and sub-prime mortgage crisis this summer and the spreading contagion to other sectors of our economy, we are not unhappy with where we ended the year as our portfolios are more defensively positioned to withstand what now appears to be a significant mid-cycle economic slowdown.As you read this letter, the U.S. economy is, at the very best, in the early stages of several quarters of zero to +2% real GDP growth with a one in three probability that we have entered a recession. In our third quarter letter we discussed how this housing bubble and collapse is much worse than the 1990 bust following the savings and loan crisis and that the severity of the spillover effects from the unwinding of this bubble on consumer spending and employment are unknown at this moment in time. One of the reasons for this uncertainty is the added financial instability that has come from the popping of the credit bubble side-by-side with the housing bubble.

The proliferation of new financial products to support this five year housing bubble included all kinds of new mortgages, bonds, swaps, and derivatives. With investment banks and hedge funds basically free from any substantial regulatory oversight, a shadow banking system was created of non-deposit institutions that are outside the purview of the Federal Reserve System. Although former Federal Reserve Chairman Greenspan watched as these twin bubbles percolated to unsustainable levels, he did correctly describe what was happening: “Uncertainty is not just an important feature of the monetary policy landscape, it is the defining characteristic of that landscape.” Weak employment numbers for December 2007 validate that the FED is substantially behind the curve in reducing the fed funds rate which most likely is headed to 3.5% from 4.25% before they right the ship. The reason they are behind the curve is simply that the FED is full of academics that have never run or managed real money in the real world.How does this predicament of higher inflation and slow growth or no growth for the economy play out in 2008? Food and energy are quite visible examples of inflation despite the fact that academics take them out of the picture and therefore, refer to core inflation as stable. We have said in the past that the definition of uncertainty is “not knowing what you don’t know,” and so with that caveat, here is what we do know:

  1. The housing debacle is not over. An estimated $800 billion of adjustable rate mortgages are scheduled to reset between October 2007 and the end of 2008.
  2. Current estimates are that about 1 million houses will default annually in 2008 and 2009 with existing home sales of about 6.42 million units per year.
  3. Residential write-offs to date are about $100 billion and total losses when this is over are now estimated to be $300 billion. The extent of the impact on the economy is unknowable as this bubble deflates because we do not know the speed or the subsequent negative “wealth effect” on consumer spending. We do know that more houses in default will add to an existing ten month inventory of homes for sale (4.3 million) and thus put downward pressure on home prices. Home prices equate to the consumer’s sense of his wealth.
  4. Economists estimate that historically having a one dollar change in wealth equates to a 5% change in consumer spending. So using the five cents per dollar change in spending, a 20% decline in housing prices on average could result in an estimated $210 billion reduction in consumer spending. Putting this in perspective, personal consumption expenditures for U.S. consumers are estimated at $9.9 trillion so a $210 billion decline in consumer spending on a $9.9 trillion base, spread out over two years, is significant but not catastrophic. However, it is equal to a little more than 1% per year reduction in real GDP growth. The decline in consumer spending from this wealth effect is, therefore, likely to be gradual and give us sub par economic growth for 2008. We project that the weakest numbers will occur in the first half of the year and gradual improvement in the back half. The FED’s rate cuts which started last summer and should continue through to the spring of this year can begin to mitigate some of the negative impacts we are now experiencing from the bursting of our twin bubbles.

How does this economic speed bump affect our stock market outlook and our portfolio structure going into 2008? Corporate profit growth (S&P 500) in the U.S. will be weak this year at 5% with foreign profits (1/3 of total profits) growing at 10%-15% and domestic profits at 2%. One of the key differences from the previous savings and loan crisis and recession of 1990 and the current sub-prime housing crisis, is the impact of the developing economies on world GDP. These economies make up 29% of world GDP, larger than the U.S. at 26%. Brazil, Russia, India, and China are growing at very high rates and even with some expected slowing in their growth rates, their impact is significant and that is good news for many of our multinational companies who are doing significant business overseas. This factor creates an important cushion and is the difference between now and the 1990 crisis. While there certainly is controversy over determining core inflation without food and energy costs, 2%-3% inflation is still the likely forecast. Despite prices approaching $100 per barrel for oil recently, the magnitude of the price gains in 2008 will not come close to matching the speculative run up in energy prices in 2007. So with modest earnings expectations of between $90-$95 for the S&P 500 for 2008, the market is priced at 15x-16x earnings which is not overpriced from an historical perspective if we are right on this inflation range. Anything greater than 3% or less than 2% inflation certainly opens the discussion for both lower and higher P/E ratios and thus lower and higher stock prices for 2008. With the FED almost certainly in an accommodative posture early this year, we look for positive stock returns of 5%-10% assuming modest corporate profit growth and stable price earnings ratios, back loaded to the second half of the year. Improved visibility on better economic growth, stable inflation, and the subsiding contagion of the twin housing and credit bubbles could produce higher total returns than our initial forecast.

The Five Mile River portfolio structure going into 2008 for taxable accounts was put in place over the second half of 2007 when we established more defensive positions with heavier emphasis on energy master limited partnerships. These positions have dividend distributions that are stable at anywhere from 5%-7% yields and growing at 5%-10% per year (Kinder Morgan, Magellan Midstream, Crosstex Energy, El Paso Partners). In both taxable and retirement accounts we have the portfolios positioned in energy, particularly natural gas (Williams, Crosstex, Ultra Petroleum), best in class oil service companies (Schlumberger, Cameron), and several growth electric utilities with dominant positions in nuclear energy exhibiting favorable regulatory environments and growing dividends (Exelon, Dominion, Entergy, Constellation Energy, Florida Power and Light Group). Finally, we have selectively added in over the last six months smaller positions in a number of larger capitalization growth stocks that exhibit strong balance sheets, substantial free cash flow generation, and managements who are owners and act like owners (Monsanto, Medco Health Solutions, Precision Castparts, Praxair, Wellpoint).The 2007 financial crisis was started by the twin bubbles in housing and financial derivative products without concern for risk. The painful resolution of this crisis will include the re-pricing of risk, a substantial reduction of debt by the consumer, and the transfer of ownership of these financial and housing assets to new owners at lower and realistic prices. The process has been underway for six months and will continue for at least another year before equilibrium is restored to these markets. We said last year that preservation of capital is very important when uncertainty and volatility are high and we will continue to adjust the risk level in your portfolio to meet that commitment. We thank you for your continued support and as always we welcome your comments, questions or emails on your portfolio and our strategy at any time.

Sincerely,

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.

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.