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Monday, March 7, 2011

The Great Recession: How to invest going forward

Two books I highly recommend reading are Too Big To Fail by Andrew Ross Sorkin and After-shock: The Next Economy And America's Future by Robert Reich, former US Secretary of Labor and currently a professor of public policy at UC Berkeley. Too Big To Fail is a riveting story of the events leading up to the near collapse of the US financial system and the moves Paulson, Geithner and Bernanke made to stabilize the system. Robert Reich wrote After-shock in response to the economic crisis and it is his plan for restructuring the US economy and reshaping our politics to bring a broader and more sustainable prosperity to our country.

Robert Reich makes some interesting points, one of which is that the wealth in the US has become too concentrated. He believes this to be problematic because it creates a surplus of capital searching for investment returns that ultimately creates speculative bubbles followed by the inevitable crash. He backs up his theory with a statistic that in 2007 (the year before the Great Recession) and 1928 (the year before the Great Depression) the share of total US income going to the top 1% wage earners peaked at an all time high of over 23%.

In reading Too Big To Fail, one thing that is very obvious to me is how our financial system is tightly controlled by a relatively small group of people that have an incredible amount of power, mainly the Treasury Secretary, the Chairman of the Federal Reserve, the Chairman of the NY Federal Reserve and the CEO's of the major financial institutions. With less major financial institutions now than before the economic crisis, it appears the power is even more tightly controlled than before the crash.

Whether Wall Street has the financial game "rigged", and/or the problem is the "rich getting richer", as Robert Reich would have us believe, it does appear, for whatever reason, these speculative bubbles and subsequent crashes are happening more frequently.

What will be the next bubble to burst...perhaps US Treasuries? The real question is how to protect oneself going forward from the wild fluctuations which may becoming more the norm than the exception. One way may be to dial back return expectations and get back to the basics of investing. For me, that means investing in things that actually cash-flow and produce a real cash-flow return to the investor over the life of the investment. So many investment opportunities that I see have no cash-flow and are based solely on future expectations. With Excel and a good set of assumptions, any investment can look great by projecting a terminal value that generates an eye-popping internal rate of return.

I think the key is to find investments that have a stable cash-flow return, then if there's a major market correction, I can hang-on, clip my coupon, and wait patiently for the market to recover.

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