PERIOD FMR* Taxable FMR* Retirement S&P 500 NASDAQ 100 Russell 2000
1st Qtr (0.57%) (3.81%) (10.98%) 2.09% (15.36%)
2nd Qtr 1.75% 2.99% 15.92% 19.42% 20.23%
3rd Qtr 8.05% 10.31% 15.59% 16.36% 18.89%
4th Qtr 9.29% 7.66% 6.04% 8.22% 3.49%
YTD 19.47% 17.65% 26.97% 53.54% 25.22%

Looking only at the performance numbers above for the fourth quarter and calendar year 2009, an investor could conclude that the stock market had a respectable and normal bounce back after an awful year in 2008. Of course, these two sets of numbers do not begin to accurately describe the enormous market volatility in the “Great Recession” year of 2009. For a quick retrospective, the market tumbled 25% from January 1, 2009 to what we have called a generational low on March 9, 2009 (676 for the S&P 500), and then rallied 65% from the March low, without significant corrections all the way to the year end composite of +26.97% (1115 for the S&P 500). This huge upward move from March 9th was the fastest climb since 1933!

In 2009 Five Mile River taxable accounts were up on average 19.47% and our qualified IRA and retirement accounts were up on average about 17.65%. The significant difference between the taxable and non-taxable performance was accounted for by the 30% weighting in Master Limited Partnerships in the taxable accounts which were up 25%-50% in 2009. These MLP’s are owners of energy infrastructures assets like pipelines and are not permissible holdings under U.S. tax law in qualified retirement accounts. So the questions we want to address in this letter include: What caused this historical volatility in 2009 and what is the outlook for 2010? Finally, we want to comment on our portfolio structure and the characteristics of the kinds of companies we own in FMR accounts.

Causes:

We entered 2009 staring at a simultaneous banking crisis, credit crisis, and a huge asset bubble bursting (housing).

As a 25 year secular credit expansion came to an end, the U.S. economy plunged into the deepest and quickest recession since the 1930’s. With credit virtually unavailable for all but the “AAA” companies who did not need financing (IBM for example), large and small businesses quickly cut expenses by cutting employees, reducing capital spending, and slashing inventories at an unprecedented 5.1% through the second quarter of 2009. As we know all too well, the crisis in the U.S. banking system spread from here to the rest of the global economy which simultaneously went into recession with the U.S. There was no neat playbook for the 2009 global recession so virtually every government and monetary authority around the world started massive monetary easing and fiscal stimulus on an unprecedented scale. Fortunately, not all of the three U.S. crises were present in every country and as the Federal Reserve aggressively stepped in with massive liquidity, many of the large growth economies (China, India, Korea, Brazil) quickly recovered. This helped both Europe and the U.S. avoid even deeper and longer recessions. The stock market plunged in the first two months of 2009 in response to this simultaneous world economic collapse, sending world equity and bond prices to what will likely prove to be generational lows. While it was difficult to appreciate at the time, the undervaluation of the best assets and the best corporate business models in March was compelling for any long-term investor with a three to five year time horizon.

The market panic of March gave way to the start of a slow and skeptical, yet steady, flow of cash reserves (earning zero) back into the U.S. corporate and municipal bond markets, followed by the U.S. stock market. The U.S. recession of 2009 ended sometime this past summer as the third quarter GDP turned mildly positive 2.2% for the first time since the recession began in December of 2007. With the Fed Funds Rate basically at zero for a full year, the Federal Reserve publicly stated that it would keep short rates low for an extended period of time, so as to eliminate the possibility of a double dip recession in 2010. Both China and India, among other developing countries, provided significant fuel to this synchronized global upswing. The stock market’s 65% bounce from the March low last year reflected both surprisingly good corporate profit performance (or less bad than expected) from the huge prior cost cutting, as well as, increased confidence that the panic was over.

Supporting a more positive outlook, retail sales have been higher than inventory builds for several months, thus store shelves are lean, indicating that inventory rebuilding lies ahead. Hopeful signs include eleven states where employment has increased in the fourth quarter and there are eleven sectors (education, health, business services, arts, broadcasting, nondurable goods, to name several), which account for almost 40% of actual jobs in the workforce, that are posting employment gains. However, housing starts were at record lows last year of around 550,000 versus prior lows of one million. Existing new house inventory is at a low not seen since 1971 of 265,000 homes. Home prices have made a bottom in many markets with perhaps only another 10% price decline for the worst of the bubble markets by this Spring. Nevertheless, a return to the pricing of 2005-2006 is unlikely for at least another five years, and we do not expect to see 1.5 million annual housing starts for a very long time . . .if ever. Unemployment claims have declined faster than 1991 and 2002 recoveries. However, as we discussed at length in our third quarter letter, with 15 million unemployed or underemployed workers, we will need at least 250,000 new jobs per month for several years to return to a 5%-6% unemployment rate. The jury is still out for sure on this point as our politicians are slowly beginning to realize that more government spending creates no new permanent jobs. This leads us to our outlook for 2010.

Outlook:

Is this nascent recovery sustainable and what is the outlook for the U.S. stock market?

This has been one very tough, severe recession and the recovery is likely to be unsteady as there are significant pockets of weakness within the U.S. and real problems elsewhere in the world (Greece, Spain, Italy, Ireland, Iceland, UK, Romania, Hungary, Latvia, and Japan for example). The European Union also faces a severe banking crisis and an ongoing bad debt problem that has not been recognized by their institutions. So, while our economic recovery is underway, it is not likely to be a powerful recovery and will face some difficult headwinds. These include continuing consumer deleveraging, a banking system that remains skittish about lending, consumers reluctant to borrow, very weak commercial real estate, potentially higher taxes from poorly conceived healthcare and environmental legislation, and finally, the omnipresent elephant in the room, the U.S. Deficit!