Thursday, November 8, 2007

Cash Flow

Tonight I want to talk about cash flow otherwise known as income. From what source do you get your income? What does this have to do with investing you ask? We’ll get around to that in a minute.

First off let me say that if you want me to show you how to put together options strategies I can’t do it. If you want me to tell you what a calendar spread is I have no idea. I have no expertise with complex hedging systems (which BTW are a waste of money unless you are a large hedge fund that can’t sell your positions without moving the market). I have no idea what the Black Scholes model is other than a way to determine option value. I have no expertise in any of these areas and I must confess that I have no desire to acquire any. There is just no need to know this kind of stuff to make money in the markets. This is all just a way for investors to make something that should be simple and boring into something that’s complex and exciting. I get plenty of excitement by hanging off the side of mountains. I want to keep my investing strategies simple.

Now what I am half way decent at is seeing the big picture. I can see the forest and not just the trees :)

Now how does cash flow fit into the big picture you ask? Well first off let’s look at the different types of cash flow.

Let’s start with earned income. A job! Security, risk free right? Well maybe and maybe not. I think before I’m done we are all going to see that there is no such thing as risk free cash flow. Security… maybe unless we have a recession then unemployment is going to soar. Also technology is now advancing rapidly. Most of the scientific discoveries ever made in the history of the world have occurred in the last 20-30 years. Your job skills could and probably will become obsolete quickly in this changing world. Also as I’ve stated before I think we are in an inflationary environment. During times like this businesses are going to have their profit margins squeezed. At times like this it is hard for business to raise payrolls enough to match rising input prices. Bottom line the employees of the world are going to get hammered by rising prices and stagnant wages. Also if you are in this category the government is going to take their chunk before you ever get your hands on your paycheck. Needless to say as an employee you have no tax advantages.

Now let’s take a look at passive income starting with real estate. First off real estate has great tax advantages. One thing going for it. If you had bought real estate back in the early 90’s you could rent your property, get a positive cash flow and on top of that normally your property would be appreciating as someone else paid for your asset. I think it’s safe to say that that category of cash flow is now kaput. Not only can you not purchase real estate at a price that will let you get a positive cash flow but your property will most likely be depreciating for the next 10 years. I think we can all agree that this category is now too risky to invest in.

How about risk free bonds? I’m going to show you why bonds are about as far away from risk free as you can get at this time. Almost as bad as real estate. Let’s say you bought $10,000 worth of 10 year notes in 2000 yielding 6.75% annually. Now let’s use that gallon of gasoline as a proxy for our inflation gauge since everyone is dependant on it. At roughly $1 a gallon your original $10,000 would buy 10,000 gallons of gasoline. Compounding that return for 7 years we get $16,860. Now let’s take that gallon of gas which is now costing $3 and see how many we can buy $16860 / $3 = 5620 gallons. Son of a B****. The damn government just stole half my purchasing power on a risk free investment. Let’s just say that inflation is just now getting started good. Let’s also agree that we don’t want to make that mistake again.

That leave’s us with two options that I think have a better chance of actual returns.
The first is to start a business. I personally have owned several businesses. There’s nothing better than being your own boss and having other people work for you. On the other hand there’s nothing worse than being the one that has to be there to solve any problems when they happen because your employees are not going to take your problems home with them. It will be up to you to handle life’s little curve balls. This of course isn’t risk free by any means either. Especially in the coming times of high inflation it’s going to be challenging to start and keep a business alive and well. But at least you are in charge not someone else. You also have some tax advantages. You get your hands on your money before the government. If you desire you can use some of those profits to expand your business or as investing capital before the government takes its share.

Now the last category: investing. For our purposes we’ll stick to investing in the stock market. Also I think we all will agree not risk free. As I’ve said many times now I think we are in a secular bear market for paper assets and a secular bull market for commodities. If you had bought stocks in 2000 you have lost a tremendous amount of purchasing power even though the Dow is considerably above the highs of 2000. Even if you bought the Dow at the absolute bottom at say 7000 and are now up 100% you have still lost purchasing power compared to that gallon of gas because that gallon of gas has increased 200%. So even if you are the best market timer in the world you have lost half your purchasing power. However if you had bought oil in 2000 you have not only kept up with inflation but you have vastly outpaced it. Same with almost all commodities. So if we are going to produce cash flow in the markets we either need to be both an excellent market timer and a great stock picker or we need to be invested in commodities because that’s were the real bull market is. On top of this investing has advantageous tax breaks if you are a long term holder. At the moment long term capital gains are taxed at a 15% rate as opposed to as high as 35% for short term gains.

Now I’ve gone over all this because I think we are quickly coming to the end of the “fun” times for this monetary inflation period. The Fed is now in a box. They need to cut rates to keep the economy growing. The last two rate cuts have produced a brief rally in the stock market that has quickly faded away and put the dollar in jeopardy of a waterfall collapse. If this were to transpire inflation would skyrocket. Here’s what I think is going to unfold. The Fed is going to have to hold off on more cuts and the economy is going to stagnate. When this gets serious the Fed is going to have no choice but to cut. The dollar collapses and inflation really starts to take off. Maybe we even see hyperinflation. This puts an even bigger strain on the economy as paychecks can’t keep up with rising prices. Standards of living decline. Multiple recessions take their toll on the economy. At some point we will have to suffer through a bad recession or possibly even a depression to clean out the excess built up during the bubble years. Historically a depression happens about every 75 years. At some point a Fed president will have to be willing to flush out all the excess liquidity like Volker did but this is going to be very painful and I have a feeling the powers that be will put this off as long as possible thus making it infinitely worse than it has to be.