Run Like Hell, Again

Welcome back old friend - volatility.

After a massive run in stocks, a day when the major indices all rallied more than one percent, and BP PLC BP stated it is restoring its dividend, traders are throwing around support and resistance levels on major indices as if they were discussing the weather. And people who work far outside the investment world are joining in as well.

I recently overheard a conversation between two gentlemen who clearly didn't know what was going on in the global economy, but knew enough to suggest what stocks investors should be buying.

Only one thing is certain in times like this: nobody knows for sure what is going to happen in the market. Whether it is one day from now, two weeks, or one year – anybody who says they know exactly what will happen is somebody you should turn and run like hell from.

And while that may sound scary, it is the exact reason that we should be invested - because in essence, markets reflect the collective ideas of millions of people. This includes emotion, fundamental data, long positions, short positions, speculation – you name it.

This collection of market inputs can lead to volatility, like we're seeing now.

There are those who think the collective ideas of market participants are something they should stay well away from. Those people should not be investors. Others, probably most of you, realize that there is immense opportunity in the stock market, and are willing to tolerate a certain level of volatility.

Wherever you fall on the spectrum, I recommend understanding both sides. The reality is that large masses of people are infinitely wise, and profoundly stupid. The difference comes down to timing, and that's why it's so difficult to pick market direction at any one point in time.

There have been a number of books written about these subjects, but two stick out in my mind. If you're interested in some extra reading, I suggest checking out both Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds, as well as James Surowiecki's The Wisdom of Crowds. These two books clearly give different perspectives regarding the implications of collective decision making, and I expect you'll enjoy both for different reasons.

***There are however, some certainties that investors should understand. The world economy has problems. There is too much debt out there, and too little savings. Too many people are taking advantage of social safety net programs, and too few people are paying into them. I'm sure you've heard the line ‘There are more people riding in the wagon than there are pulling it' by now.

And it's true.

A student with third grade math skills is seasoned enough to realize that if you subtract more from a checking account than you put into it, you have a problem on your hands.

But all is not awful. There are real businesses out there earning money, and many American companies have cash on the balance sheet, lots of cash. And most people are still working and bringing home a paycheck. Not all homeowners owe more on their houses than they are worth.

At the end of the day, cash flow is critical. That holds true whether considering personal finances or corporate finances. And maintaining reasonable debt levels given those cash flows is equally important.

So when considering the volatility in the markets right now, it is critical that investors understand that at the end of the day, cash is still king.

The markets are going to punish the stocks of companies that don't have cash, and reward those that do. Take a look at your portfolio and make sure you own stocks in companies that have good cash flows. It's ok to hold some that are leveraged as well, but make sure you keep it in balance.

If you have any questions or concerns about a particular company's cash flow, feel free to send me a question and I'll take a look at it. My address is: editorial@smallcapinvestor.com