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Mr. Market Miscalculates

James Grant's 'Mr. Market Miscalculates' Is Nothing Short of a Deep Value Investment
by: Miguel Barbosa October 13, 2009

I am happy to report back after reading Mr. Market Miscalculates by James Grant. Our friend Glenda provided us with a copy to review. We are delighted with the book - so much so- that we venture to call this book a deep value investment. You pay a small sum and receive a priceless collection of essays.

Overall the book is a pleasure to read. Grant, a master wordsmith and investment theorist, manages to educate, preach, and entertain. Unlike most newsletters which are immediately discarded, Grant’s essays stand the test of time. To think that you could have read Grant’s essays and avoided the subprime crisis, Fannie Mae (FNM), and other financial mishaps is reason alone for reading this book.

Rather than present you with my opinion, I have included a collection of quotes from the book. I’m confident that once you read Grant's words you will rush to purchase this masterpiece.

Here are our favorite quotes (and notes) from the book. All material is cited from "Mr. Market Miscalculates" authored by James Grant. Any mistakes are my own responsibility.

I. Topics & Relevant Quotes

Grant’s Prediction (P 352)

“My bet is that, come the next bear market in credit, correlations will prove to be shockingly high across the full spectrum of debt instruments. It will turn out that everything was correlated to credit itself – on the ability to borrow on terms over which posterity will shake its head muttering, what were they thinking”

Booms & Busts (P 75)

“Aberrations ….must eventually pass the test of supply and demand” “New eras are cut short by the financial behavior they reward and condition”

Mindset of Fellow Bears (P 77)

“..Bears believe markets are cyclically inexact, and prone to exaggeration at both extremes”

Alan Greenspan & Deficits (P 88)

“Greenspan never understood the problem. This defect does not mean he will never hit on the solution. What it does suggest, however, is that he will come to it belatedly and likely for the wrong reasons”.

Bonds vs. Real Estate (P 95)

“Which would you prefer? Bonds have no windows to wash, walls to paint, carpets to vacuum, tenants to litigate with or governments to pay property taxes to. On the other hand, the building wouldn’t be subject to early call if interest rates fell. Then again each stream of income – rentals and coupon payments- is denominated in dollars of which the world is very long. And if interest rates and/ or the inflation rate were to climb? Depending on the timing of lease expirations the building's new management could raise rents. Bondholders could reinvest coupon income at higher and higher yields and….receive 100 cents on dollar at maturity”

But…

“Neither building nor bonds provide the margin of safety that value seeking investors demand”

Inflation and Deflation (P 107, 108 109, 302)

“What inflation is not we believe, is “too many dollars chasing too few goods.” Pure and simple, it is “too many dollars” What the redundant dollars chase is unpredictable…..On Wall St, such inflationary episodes take the name “bull markets”. They are always welcome.

“Deflation is not quite the opposite of inflation. We would define deflation as too few dollars chasing too much debt” “But the world is doing itself no favors by so narrowly defining inflation & by so carelessly crying deflation”

“In relation to income, the stock of debt has been rising for decades,. If the price level reversed course and declined uncounted net debtors would struggle to stay solvent. Falling prices, even if they were not caused by a credit event, could easily provoke one. “

“Let the world’s central bank define inflation as “core CPI” no food, no energy, no house prices – and that arbitrary inflation measure will inevitably lose some of its economic significance. As a central bank is congratulating itself on a brilliant job of inflation containment, house prices go through the roof”

Interest Rates & Real Estate (P 110, P 111, P124)

“Rising interest rates must sooner or later cause the marginal third home owner to become a two home, or one-home or even a no-home owner. One would spouse that a similar chair reaction is going to take place in other highly leveraged sectors of the U.S. Economy”

“The advent of futures and options, of swaps and securitizations has facilitated American borrowing and lined the consumer pockets with several hundred billion dollars over the past few years, particularly with the turning of unsecured credit card debt into asset backed security agreements”

“For ourselves we fault the Fed not so much for resisting the so-called deflationary forces of 2002-2004 as for failing to anticipate that its reflationary acts would have wide ranging consequences, not all of them pleasant. Even today, our monetary masters appear blinkered to the unintended second, third, and Nth order effects of the plunging funds rate”

The Housing Market (P 131, 139)

“Insofar as high trading volume characterizes a speculative market, the American house market maybe described as a speculative. If so, it’s a thin reed on which to support a bullish GDP forecast”

“Those heavily leveraged homeowners, would in car lingo, be upside down, if house prices pulled back by 10%. That is they would owe more on their asset than the asset is worth in the market.”

“To draw a bead on US real estate activity,….take price times volume: Multiply the number of home sales by the average home price. Now divided that value by the GDP. The answer expresses the intensity of house fever”

“What set of national causes could instigate a coast-to-coast bear house market today? We submit three: wild and wooly mortgage finance; the propensity of market-determined prices to revert to the mean, and the tendency of flyaway real estate markets to become the drivers of economic expansion rather than the mere beneficiaries of growth derived from other sources.”

CDOs (P 193, 195)

“CDO alchemy is also very much like the kind employed in conventional asset backed securities. In a CDO, as in an ABS mortgage scientists and rating agencies perform a miracle of distillation.”

“We say this as nonbelievers in the magic by which a collection of subprime assets can be reconstituted into triple and double A rated liabilities”

Glass-Stegall (P 200)

“The history of Glass-Stegall teaches many lessons, one of which is that the law of the land is cyclically variable; there is one set of rules for bull markets, another for bear markets”

The Fed & Greenspan (P 242, ,255, 269, 282, 293, 301, 302)

“And now this one man says that he didn’t know about the stock market bubble, couldn’t’ have known and , even if he had known, wouldn’t have been able to make a move against it. It isn’t exactly a great advertisement for a monetary dictatorship.”

“Only one of the troubles with bubbles is that, after they pop, ultra low interest rates and extraordinary rates of credit expansion lose their stimulative potency.”

“..Now the very people who erred in the 90’s are prescribing for the 00’s. The notions being prescribed are exactly the ones you would not have expected. It’s the shock of the down cycle that Greenspan…is weighing a de facto nationalization of the Treasury yield curve”

“It wasn’t everyday low prices they feared, but the financial consequences of falling prices in a heavily leveraged economy”

“The soundness of a central bank varies invesrsely with the breadth of its mandate. The more it’s expected to do , the longer the odds against its success. The Fed…is expected to deliver the earth (price stability), the moon (full employment) and the sky (a solvent financial system). “

“The central banks believe they can control future events. We say that events control the central banks”

“As inflation targeting is inherently forward looking, this means that dozens of central banks have gotten themselves into the stargazing business”

“It’s not that Greenspan can’t hit the target…the problem is that they don’t hit the new target that pops up unannounced outside their field of macroeconomic vision.”

LBOs & Private Equity (P 339, 340)

“The private equity business owes its prosperity to a persistent mispricing of debt….cheap debt is the sine quanon of today’s deliciously rich, fee resplendent deals.”

“If forgiveness is a virtue, the debt markets are going to heaven”

II. My Favorite Quotes From Mr. Market Miscalculates:

(P 96, 208, 210, 216, 223, 229, 259, 265, 304, 307, 309, 316, 348)

“Rare is the individual who can imagine a different set of circumstances that those that surround him. Rare still is the organization that can imagine them. “

“As a rule, investors see what they want to see”

“It wasn’t the lack of rules and regulations that raised the depravity index in American finance. It was the conditioned belief in a new era”

“The impetus to reform is only latent in bull markets; it’s during bear markets that the rules are changed”

“It’s an investor’s bounden duty to take the world as it is, not as it should be or could be. In the world in which we live, the politicians are gaining on the capitalists”

“Trusting in American markets & American standards of disclosure & accounting, foreigners have willingly exchanged their merchandise for our securities”

“…here we encounter the difference between physics and economics. Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings”

“The more dependably the Fed fends off disaster the bolder and more leveraged investors become. The bolder investors become, the higher the markets go. And the higher the prices the greater the leverage, the more likely does a financial accident become. “

“Mistakes are what come from getting out of bed in the morning”

“It would take a nation of saints to resist exploiting the privileges accorded to the owner of the reserve currency franchise. Imagine If this priceless gift were one day settled, out f the blue, on an unsuspecting country.”

“To be long gold is, in a grand thematic way, to be short the socialization of risk”

“The elixir called liquidity is the most powerful bankruptcy deferral force of all”

“In financial markets the more people write hurricane insurance , the more likely it is that the disaster will happen because the people who know you have sold the insurance can make it happen”

III. Most Insightful Stories & Examples From Mr. Market Miscalculates

1st Example: The Great Plains 1886 real estate market (P146-154):

In this market people pushed up western land prices to highs that in real terms, haven’t been seen since. Conflicts of the 1880s were similar to those in the 2000s – Grant says,

a. In the 1880’s “principals in this case the savers wanted safety (and yield), agents in this case lenders wanted commissions. “ Not for the first or last time in financial history did the agents fared better than principals.

b. “frontier due diligence was no better in 1880’s than 120 years later.”

c. Moral of the story, “ in order to create a really big asset-price bubble, a central bank is neither necessary nor sufficient. A critical mass of human beings is all that’s required”

2nd Example: Private Investor Fournier Buy Protection (P 176)

“What I have done…is put together a portfolio of this stuff (credit protection on tranches of mortgate backed structures) I have 750million of this stuff shorted. My Cost is 1.9% (or 14.25 million a year). My return could be 750million. As risks and rewards go we judge not bad”

3rd Example: Fine Art of Security Analysis (P 389) Suggestions on how to tweak the Graham criteria by Peter Walmsley.

1. Quality Of Earnings Test – Calculate variance between normalized earnings & plain old gaap earnings. Go back every quarter for 10 years. Compare eps on the income statement to eps from continuing operations” Variance of more than 15% is a red flag…this weeds out companies using nonrecurring charges for every quarter.

2. Substitute the debt to equity for debt to working capital. ..this unmasks companies using big bath accounting to depress book equity to inflate roe

4th Example: The Bank of Graham & Dodd – Conservative Banker Karl Hill Of Monroe County Bank in Georgia

*Wonderful story of a successful, smart, and conservative banker.

IV. Additional Reading Recommendations found in Mr. Market Miscalculates

1. Wall Street Under Oath: The story of our modern money changers – By Ferdinand Pecora

2. Fiasco; The inside story of a wall street trader

3. BIS paper by Claudio Borio & Philip Lowe

4. Banking & The Business Cycle By CA Philips, TF McManus And RW Nelson

5. “Crisis & Cycles” By Wilhelm Ropke

6. A History of the Federal Reserve By Allan H Meltzer

7. The Fed By Martin Mayer

8. The Road To Delphi By Michael Woods

9. The Anatomy of an International Monetary Regime By Giulio M Gallarotti

10. That which is seen & That which is not seen By Frederic Bastiat

11. Ubiquity By Mark Buchanan

12. A demon of our own design: markets, hedge funds, and the perils of financial innovation by Richard Bookstaber

13. My Life As A Quant – By Emanual Derman

14. Schiffs Insurance Observer