PERIOD FMR* S&P 500 NASDAQ 100 Russell 2000
1st Qtr (3.14%)** (10.98%) 2.09% (15.36%)

** YTD FMR Performance is an estimate. Actual performance data will be sent when available within two weeks.

FMR taxable and qualified portfolios outperformed the S&P 500 in the first quarter after declining in parallel with the stock market in 2008. Our more defensive positions that we thought would cushion the downside in 2008, finally reacted as we expected in the irrational panic of the first quarter. This was a first, small positive sign that the worst of the panic selling may be subsiding. The anxious uncertainties that create fear, and cause poor decisions based on risks not easily assessed, have begun to quiet down. Many of our companies with strong business models and balance sheets, along with free cash flow, are beginning to stand apart from the crowd and are no longer participating on the panic selling days. In this letter, we discuss where we think we are in the timeline for this financial crisis and how we see the longest recession since the 1930’s evolving in an end game that most certainly will bring a close to this sad chapter in the U.S. economy.

The extreme market volatility of 2008 continued into the first quarter of 2009 with a vengeance equal to what we witnessed in the fourth quarter. The S&P 500, after recovering 20% from the November 21st low of 741, made a new low of 676 on March 9th, down 57% from the market’s high of 1562 in October of 2007. No sooner had this new panic low been put in place, than the market proceeded to bounce up once again about 20% in less than a month, only to fall back at the end of March. The beginning of April continued this recovery from March 9th with significant breadth in the gains across many sectors. With two substantial bear market rallies in less than six months, this bottoming process may not be over but significant evidence of a bottom is mounting. What do we expect for the markets and our investments as this financial crisis and deep recession play out to the conclusion of this historic period?

What we are experiencing may be named the “Great Recession.” The U.S. is, unfortunately, the main actor in what is now a synchronized global downturn. Already the current recession is the weakest in 50 years! Peak-to-trough, real GDP has already surpassed the decline in 1974. There are four key problems today that have been well publicized in the media: 1) The Banking System 2) Credit Markets 3) Employment 4) Housing.

While the banking system is still not functioning on all cylinders, the latest proposals from the FED and the Treasury on how to remove the “toxic” assets from the banks look promising. The success of this new plan, called “PPIP” (Public-Private Investment Partnership), is crucial to cleaning up our largest banks’ balance sheets so that they can resume normal lending to both businesses and consumers. The incentives to attract private capital alongside taxpayer capital look to be attractive enough to begin moving these problem bank loans and securities out of our banks. The recent modification of mark-to-mark accounting will likely speed up the cleansing of bank balance sheets and is a clear plus for our banking sector recovery.

The credit markets are showing positive signs of returning to normal in several sectors as the FED has been aggressive in restoring liquidity to the money market funds, commercial paper, mortgage backed securities, credit card securities, student loans, and auto loans. To completely move all of our credit markets back to normal functioning, additional work will need to be done. These important markets include commercial mortgage backed securities (office buildings, hotels, warehouses, apartments) and the securitized “jumbo” home loan mortgage market. These two big credit markets are currently not functioning and need to be revived to bring the economy out of recession. Only the FED and the Treasury have the scale to open up these markets, and we expect progress toward this goal over the next twelve months. Realistically, it could take another year to restore the confidence in all of our credit markets to where they function without intervention. The improving credit news is appearing in the form of narrower credit spreads, significant money supply growth, and a very attractive slope to the yield curve. These developments are the precursors to an eventual recovery in 2010.

Employment is a lagging indicator (along with consumer spending and house prices), but consensus estimates are now that unemployment will peak close to 10% in early 2010 if not sooner. The effectiveness of the Treasury’s Rescue plan in putting people back to work is unlikely to be effective in 2009 because of its limited focus on permanent private sector job growth. Creating significant numbers of new private jobs will require pro business initiatives that build confidence in our small businesses, as they create 70% of all new jobs in the U.S.

Finally, this financial crisis that morphed into the “Great Recession” started with housing and will have to end with stability in housing. Nationwide housing prices are already down 25% and with a decline of another 10%-15%, the house price-to-income ratio will be back to normal and affordable in relationship to household income. Estimates of three million excess homes in the U.S. today are probably close to the mark and there is simply no quick way to make this inventory disappear. The supply-demand imbalance will have to work its way to equilibrium over the next two to three years as natural market forces bring in new buyers who have the financial credentials to own a house. Here’s some good news - inventory of new houses has declined 42% from their historic peak in 2006, while housing sales have turned up, thanks to the combination of 4.75% mortgage rates and the record price decline for houses (ISI 3/30/09). California, one of the hardest hit in the housing debacle, has seen housing prices decline 54% from their peak in 2006, but sales have now surged 128% since the bottom in 2007 (ISI 3/26/09)!

The summary statement on these four factors is simply that the causes of this “Great Recession” are not the normal causes of the typical business-cycle recession. U.S. businesses and consumers had too much debt, and we will continue to witness the largest deleveraging (paying down debt at all levels) in the history of the U.S. Until this gorging on debt has been paid down to reasonable levels, there will be nothing typical about this recession or the recovery. So, what are the implications for the market, for investors, and for the kinds of investments that make sense amidst this uncertain landscape?

We are now sixteen months into the longest recession of modern times, but history tells us that markets always lead economies out of recessions, and not the other way around. Economists do not accurately predict stock markets, and markets always bottom out when the media headlines reflect the worst news, as they are telling us what happened yesterday. Headline unemployment numbers, housing prices, consumer spending, business and consumer loan growth are all lagging indicators and do not help investors anticipate the turn in the stock market. The current 10-year (-2.6%) and 40-year (-4.3%) annualized returns for the market are three standard deviations (extreme low probability) below normal and regression to the mean (positive returns) is a much higher probability than a year ago. Stocks are less risky today despite the current gloom, and potential returns are higher than anytime in the past few years. While you may perceive risk to be higher, the real risks of owning common stocks are actually falling.

Although we intend for these comments to be encouraging for the long-term investor, we do not know when the next bull market will start, or whether this bear market has made a bottom on March 9th. This cycle is different in the major ways we have discussed and the end game is likely to be different as well. The U.S. economy will be smaller and growth will be subdued for perhaps several years as debt is paid down. Consumers and businesses need to plan for this recession to last until the end of 2009 with a slow recovery thereafter. The U.S. debt bubble gave us too many houses, cars, retail stores, fast food restaurants, and coffee shops. The road back to “normal” economic growth of 3%-4% will be difficult as it will require government policies that encourage and support the private sector. If we raise the confidence of the private sector to innovate and create new opportunities and jobs we should find our way back to prosperity and a higher standard of living. However, it will be impossible to tax our way to prosperity and will be counterproductive to rely on transitory tax relief, one time refunds, and ‘pork barrel’ spending. While the U.S. can run multi-trillion-dollar deficits for a few years, it cannot run them for long without serious consequences for interest rates and inflation.

Buying stocks anywhere near the current low valuations that we are experiencing (the price earnings ratio for the S&P 500 is below 11x on 5-year average earnings) has almost always resulted in higher than average long-term returns. While there are no guarantees and no “normal” in this economic cycle, a rebound to 1000 on the S&P 500 from today’s level is a 25% return and not unreasonable within the next 24 months in what is likely to be a long road (five to seven years) back to the previous high of 1562. What have we been investing in for our FMR portfolios?

Defense of Dividends:

Despite the savage beating of stock prices and the cutting of dividends in this recession, there are great individual stock opportunities. Dividend payments are holding up better than stock prices and this has made current yields attractive to us as a relatively safe haven in the middle of this storm. While we have always focused on finding companies that generate free cash flow, increase their dividend, and buy back shares, we have redoubled our focus on finding companies that have a record of raising their dividends year after year and have the balance sheet to protect those dividend payments. In most cases, shares of dividend companies outperform the market over the long-term. Nevertheless, stocks with dividends did not offer traditional protection during the second half of 2008. But there is now evidence that during the first quarter, dividend paying companies did protect our portfolios as we would normally expect. Companies that have increased dividends for at least five years have beat the market in every year from 1972-2008 (8.9% vs. 6.2% for the S&P 500). Beyond our focus on Master Limited Partnerships in the energy area, we have added high quality companies that provide essential goods and services where dividend growth is important to the management. Recent additions include companies such as Waste Management (largest waste hauler in the U.S.), and Paychex (second largest computerized payroll processing company in U.S.). Other recent dividend growth additions with excellent yields include Intel and AT&T. We expect that our emphasis on this combination of high quality business models coupled with above average cash dividends should produce positive and more stable returns for the duration of this recession and recovery.

We appreciate your support and encourage you to contact any of us at any time to discuss your investments or other financial matters where you would like a different perspective.


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.