The Great Reflation: A Book Review

The Great Reflation, by Anthony (Tony) Boeckh, is a brilliantly crafted book that gives the reader a fundamental top-down understanding of how markets interact with each other. As long-time readers of BCA (Bank Credit Analyst) research, much of Boeckh’s message is a review of what we’ve learned over the years. But for most readers, who haven’t invested in BCA, Boeckh’s views will be a revelation. While Boeckh currently publishes his own investment letter, from 1968 until 2002 he was chairman and editor-in-chief of BCA publications, publisher of The Bank Credit Analyst. Many would say he is largely responsible for BCA’s stellar reputation among institutional investors for providing exceptional independent research. I suspect that anyone who reads this book will instantly see the genius in how Boeckh sees the world.

The title, The Great Reflation, says it all. The book offers a thorough overview of the market forces that led to the Great Recession, and then goes on to describe the unprecedented risks posed by policy makers’ efforts to reflate the economy and avoid a new Great Depression. Part One of the book is a primer on how credit creation is a driving force in the market cycle and how fully understanding the cycle from a “top down” perspective can lead investors to a better understanding of market risks and opportunities. Part Two of the book discusses asset allocation and the major asset classes that investors should consider when building a diversified portfolio, including U.S. stocks, interest rates and the bond market, the U.S. dollar, gold, commodities, and real estate. Part Three of the book is a somewhat gloomy and overly political view of the future. As an example, Chapter 14 is entitled, “Declining America, Will it Recover?” Fortunately Boeckh’s gloomy assessment of U.S. politics and policy makers does not in any way take away from the clear and concise lessons he shares throughout the book on how to build portfolios and assess investment opportunities.

For the curious, Boeckh generally likes stocks and dislikes bonds, gold, commodities, and real estate, although he points out that all of the above could outperform for a short period of time in the Great Reflation. The one surprise for me as a long-time BCA reader is that Boeckh subscribes to what he calls Long Wave economic theory, or what many readers may recognize as Kondratieff waves. I don’t recall BCA ever emphasizing long waves, although Boeckh goes out of his way to put the theory into the proper context and cautions us not to be overly deterministic in its use. In fact, so much of this book echoes the thoughts and philosophy of Pinnacle that I spent most of my time nodding my head and agreeing with the author. Do yourself a favor and make the time to read this book.

Why Didn’t I Say That?

The next book on my summer reading list is The Great Reflation, by Tony Boeckh. Boeckh is the president of Boeckh Investments, Inc., and was the chairman and editor-in-chief of BCA Publications, publisher of the Bank Credit Analyst, from 1968 until 2002. Boeckh was largely responsible for building BCA into the globally respected independent research company it is today. We are long-time subscribers. My Baltimore to LA to Fresno to Visalia and back travel schedule last week gave me a good head start on reading Boeckh’s book and I expect to be writing my review of it for you by next week or so. However, there is one paragraph in the introduction that is so brilliant that I had to share it now. Here is what Boeckh has to say about the investment process:

“A framework of analysis for understanding markets is not the same as building a model or set of indicators fitted to back data. I can assure you, from a lot of experience, that they always break down. An eclectic approach that is based on common sense, strong logic, and objective data, balanced by right-brain intuition and lots of curiosity, is what works best. The investment world will never be deterministic, never amenable to scientific models, at least for any period of time. Some approaches work well in some periods, other approaches in other periods. Successful investors not only know how to think outside the box but, from experience, know what to pay attention to in each market environment.”

I’ve read this paragraph four or five different times and I suggest you do the same. I’ve typed it twice (because I didn’t properly save this blog post the first time I wrote it). I intend to have it set to music. I’m hiring a rap artist to “rap” it for younger financial professionals. I’m going to find an artist to sculpt this quote in metal and in stone, and I’m having it burned into wood. There are times when writing a blog post is difficult, and there are times when they seem to write themselves. But this time Boeckh wrote it for me. I can’t imagine a clearer statement of our philosophy of money management at Pinnacle than this one. We try to remember that “successful investors not only know how to think outside the box but, from experience, know what to pay attention to in each market environment.” This is a particularly difficult market environment and we continue to invest our managed accounts using “an eclectic approach based on common sense and right brained intuition.” It’s unfortunate that it is impossible for the rest of Boeckh’s book to be as perfect as this paragraph. I wish that I had said it myself.

This Time Is Different

I just returned from Las Vegas where I attended a four day investment conference. The eight hours of flying time (round trip) offered a great opportunity to get caught up on my reading list. This Time is Different, Eight Centuries of Financial Folly, is an immensely important book written by Carmen Reinhart and Kenneth Rogoff. If you haven’t heard of it, don’t worry. It’s not the sort of book that is going to challenge Suzy Orman on the financial best seller lists. But if you are an informed institutional investor you would find it impossible to miss the many references to this book this year by the best and brightest analysts. So, having read about it all year, it was time to plow through it myself.

Reinhart and Rogoff’s book is a titanic work of scholarship where they create a database that contains the data on eight centuries of financial crises. They categorize financial crises as inflation, currency crashes, currency debasement, banking crisis, and internal and external debt defaults. The author’s empirical research is based on a comprehensive database on global financial crises that they created from a number of sources. The data comes from sixty-six countries in Africa, Asia, Europe, Latin America, North America, and Oceania. Readers will find that much of the book discusses the methodology the authors used to analyze data and present it, which I suppose is wonderfully exciting to economic historians who are thrilled with this important addition to the literature, but for the rest of us it makes for some very dry reading. If you can stick with it, it is easy to see why the book has been such a sensation among institutional investors. The book provides us with historical benchmarks to measure the economy and financial markets before and after financial crises. It’s hard to imagine a more relevant discussion.

The conclusions reached by the authors are rather depressing. Economic crises that are caused by financial crises take much longer to resolve than other financial downturns caused by normal changes in the market cycle. In addition, few countries are immune from crisis and, interestingly, in many cases developed countries are not as dissimilar from emerging markets as you may think when it comes to financial crisis. Investors hoping for a V-shaped economic recovery will not find much solace in the historical record. The authors spend several chapters exploring the causes and impact of our current financial crisis, what they call, the “Second Great Contraction,” which is the only global financial crisis to occur during the post WW-II period. They conclude that the warning signs of the current crisis were easy to see but were ignored by policy makers who suffered from the misplaced idea that “this time is different.” The economic implications of this book are clearly troubling for those fearing a double-dip recession. However, the research presented on historical stock prices before and after financial crises seems to show a V-shaped bottom in equity prices after the crisis. If the global composite holds, it would be good news for bullish investors. Of course that begs the question of whether this crisis has been resolved or if it is still evolving. This is a great book for serious investors – but you’ve been warned – it isn’t the most entertaining book you will read this year.

The Big Short, Inside the Doomsday Machine – A Book Review

The latest book on my summer reading list is The Big Short, Inside the Doomsday Machine, Michael Lewis’s amazing book about the hedge fund investors who managed to find a way to bet against the U.S. subprime mortgage market before it blew up in spectacular fashion. If you are looking for a book that simplifies and explains many of the derivative mortgage products that are now part of the vocabulary of any investor, then this is the book for you. Part of Lewis’s genius as a storyteller is his ability to explain complicated financial stuff, and this book doesn’t disappoint. If you’ve had a secret longing (come on…admit it) to understand Residential Mortgage Backed Securities (RMBS), Credit Default Swaps (CDS), Collateralized Debt Obligations (CDOs), synthetic CDOs, etc., this is a way to learn by being engrossed in a fantastic story about compelling people.

What is the real story of the book? For me it is a story of the type of investors who are true value investors. These are people who look at the world in a different way and have the ability to disagree with the consensus. In this case, the hedge fund managers that Lewis introduces us to basically reach the conclusion that the consensus is wrong about U.S. residential real estate, the U.S. mortgage origination and distribution system of underwriting mortgages, the level of risk in mortgage-backed securities and their derivatives, and the entire Wall Street apparatus of the world’s largest investment banks who ultimately packaged and sold hundreds of billions of dollars worth of subprime and Alt-A mortgages. In short, these hedge fund managers reached the conclusion that they were right, and virtually everyone else was wrong about the state of finance around the world. Not only do they reach the most amazing contrary opinion of the century, but they then risk everything they own to invest their view. I suppose when you can buy insurance on subprime mortgages (a way to sell-short or bet against the value of the mortgages) for 3 cents on the dollar, the value characteristics of the trade seemed obvious…to them.

And what is the defining characteristic of these genius hedge fund managers who bet it all and made hundreds of millions of dollars when the U.S. residential real estate market fell in value and the underlying mortgage products imploded? They were social misfits. One was eventually diagnosed with Asperger’s disease, although he attributed his inability to get along with people to having a glass eye. Here is Mike Burry, one of the heroes of the book, describing his struggles to get along with people: “When trying his best he was often at his worst. ‘My compliments tended not to come out right,’” he said. “I learned early on that if you compliment somebody it’ll come out wrong. For your size, you look good. That’s a really nice dress: it looks homemade.” Burry is one of many characters that are so socially inept that apparently their only recourse was to lose themselves in finance. I never thought that I would meet such interesting characters in a book about the subprime mortgage market, but there is a lot to learn from them if you aspire to be a value investor, or want to better understand value investing. This is a great book that’s easy to read. If you have some time left this summer, take a shot at it. Next on my reading list: This Time its Different, Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff.

A Blog-Sized Book Review: Too Big to Fail

My recent business trip to Tucson and Fresno gave me the opportunity to finish reading Andrew Ross Sorkin’s book, Too Big to Fail: The inside story of how Wall Street and Washington fought to save the financial system - and themselves. Here are a few comments about the book that you might not read in any other book review.

Sorkin’s book is written in a style that puts you in the room with all of the players in the crisis. Since he obviously wasn’t there to hear what was actually said first hand, as a reader we are relying on his research to be accurate. Is this history or fiction? This literary device is absolutely gripping for the reader, but it requires us to be a little suspicious about the details.

The financial crisis created an amazing environment of forced deal-making as the major investment banks cast around looking for merger partners. Sorkin introduces us to many of the characters in each deal, which in turn gets to be a lot of characters. By the end of this book you may wish you took notes on “who’s who.” We get a fascinating look into how quickly hundreds of bankers can assemble in New York at a moment’s notice when called, and a different appreciation for corporate jets.

Warren Buffet comes across as an unlikely hero in this tale. The bankers obviously fear him and don’t want to make a deal with him because he demands “too much value.” I was struck by an early scene where Buffett settles in for the night to personally read Lehman Brother’s annual report and decides there are too many outstanding questions for him to pursue a deal. I just love the vision of the Oracle of Omaha doing his own homework to turn down a $5 to $10 billion deal (he later invests in Goldman Sachs).

How about Treasury Secretary, Hank Paulson, so exhausted in trying to put together the TARP legislation, that he has dry heaves at the office? I thought Paulson comes across as a heroic character in the book…a view that I didn’t have prior to my read.

I particularly enjoyed the language of the deal making among the major players. CEO’s of huge investment banks calling each other to say, “It might be interesting for us to have a conversation,” which meant, “I have to do a deal with you or we will be out of business next week.” Several banks apparently came within 24 hours of joining Lehman in bankruptcy.

I remember Pinnacle’s decision to sell our financial sector equity positions in February of 2009. At the time we thought the entire sector had become nothing more than a speculation on government intervention in the market. Reading the book confirms just how correct we were in our assessment, and just how close we came to a complete economic catastrophe. Sorkin gives us an insightful look into the power of government intervention in the financial markets in 2008. I wonder if there is the political will to do anything even remotely similar in the future in the U.S. I doubt it.

Atlas Shrugged – A Three-Paragraph Book Review

As any of our analysts will tell you, the amount of technical reading needed to keep up with the markets is enormous. We have daily, weekly, and monthly investment research to digest and it leaves little time to read (or write) books. However, recently I decided to get caught up on some of the reading that I have been putting off, and the book that made it to the top of the list was Atlas Shrugged, the famous book by Ayn Rand. The book is about Rand’s philosophy of objectivism, which holds that the proper moral purpose of one’s life is the pursuit of your own happiness or rational self-interest. The story is about a powerful group of industrialists who go on strike and retreat from the world until the rest of the world sees the error of their ways. The oath to join this powerful group says it all, “I swear – by my life and my love of it – that I will never live for the sake of another man, nor ask another man to live for mine.” To say the least, the book has become a rallying cry for those who believe in free markets.

For the past two years I have been hearing more and more people in the financial industry referring to this book, and now I know why. Ayn Rand is perhaps most well known for being one of Alan Greenspan’s early “gurus” and a major influence on his philosophy about free markets. Knowing that the country is about to focus on regulating financial markets (see last Friday’s sell-off on news of the $1 billion lawsuit against Goldman Sachs) where the rhetoric will be all about the social good, Atlas Shrugged certainly becomes a very relevant book to read. It’s worth mentioning that my version was 1,168 pages long (with no pictures) and throughout the book Rand’s characters give several speeches that are so long that they are exhausting to read (I will never admit to skimming any of them). Once you get started, the book is a surprisingly good read. It’s a surprisingly good story. Here are a few other insights into the book you are not likely to get on Wikipedia.

The villains in the book are unbelievably evil. They are witless, spineless, and totally and completely without any redemptive qualities. The heroes of the book, the industrialists, are saintly in their goodness. Clearly Rand wants us to be able to tell the good guys from the bad guys. The book was copy written in 1957, and the characters all smoke cigarettes like chimneys. It is very weird to read. Every scene involves someone, good or evil, chain smoking. Finally, the heroes, the captains of industry, who are the protagonists of the book, are industrialists who run railroads, copper mills, steel mills, and manufacturing plants of all kinds. Considering how the American economy has evolved, these swashbuckling leaders of industrial production seem strangely out of place.

Next up on my list: Too Big To Fail by Andrew Ross Sorkin.