$50 BILLION THAT WILL BE REMEMBERED

When the news broke about the $50 billion Ponzi Scheme that Bernie Madoff engineered over a twenty to thirty year period, I knew the story rang a bell. I went back through my records and found the original Barron’s article in 2001, and written by Erin Arvedlund. Included in her excellent research were quotes from several well known Wall Street veterans where they openly questioned Madoffs ability to consistently generate 15% plus returns, year after year, in good market or bad. All of the warning signs were there, and lots of bright people believed that this guy was running a huge scam. They were right, but no one seemed to care.

I contacted Erin a few days ago about the article and found her comments most interesting. “After I wrote the article, nothing happened. No one contacted me from the SEC or anything. I found that pretty strange….the story just died”.

As long time subscribers to the VRA know, I’ve been writing about the vast conflicts of interest on Wall Street for years. Having spent 15 years in that industry I witnessed similar things on a regular basis, yet its rare when anyone is really made to pay, or when real changes in the investment business actually take place. And we wonder why investors are pulling all of their money out of the stock market, many never to return,

Well folks, it looks like we’re finally going to get our first real perp walk. Too bad that it comes much too late and that it has nothing to do with what got our economy and markets into the mess they are in today.

We should be in the middle of the Obama Christmas bear market rally, but I believe that the news of Bernard Madoff's $50 billion fraud will hit us like nothing else -- not the fall of Lehman Brothers, not the death of Bear Stearns, and not the string of insolvency announcements of one household name after another.

Madoff will be the blow that reignites the worst economy and bear market since the Great Depression.

Madoff’s story… that he ran this gigantic fraud by himself… is 100% unbelievable. There’s simply no way that one man alone could not have done the work of inventing and cranking out thousands of statements every month, not to mention keeping track of the comings and goings of billions of dollars. Madoff has partners in crime and unless they have Inspector Clouseau running this investigation, we should know the full story soon.

So, the Wall Street Journal says to its readers, "Could your investment manager be another Bernard Madoff? If someone like Mr. Madoff can be accused of running a $50 billion Ponzi scheme, can investors anywhere sleep easy? Ordinarily, when you are picking an investment manager or financial planner, you're given some common-sense advice. Avoid managers who are unknown, or unregulated, or come without good referrals, or haven't been in the industry long. But none of this would have saved you from Mr. Madoff. 'This guy had oodles of referrals, at the highest levels,' notes Duane Thompson, a managing director at the Financial Planning Association in Washington. “He was former chairman of Nasdaq. He'd been in business since 1960.”

Fear, confusion, and mistrust have been increased by the absence of government supervision or regulation. The SEC admits “it did not do its job”. Really? Please tell us something that we don’t already know! And the media continues to call this “the biggest ponzi scheme of all time”, but we know that to be a lie as well. Social security (aka, social insecurity) is of course the biggest ponzi scheme ever. Madoff is not even in the same ballpark.

Still No Perp Walk

So far the government has thrown away approximately $10 trillion of taxpayer’s money to bail out Wall Street and the banking industry and we’ve yet to see a single perp walk. Think about this for a moment. Goldman Sachs and JP Morgan, along with several of Wall Streets most prestigious firms engineered the exact derivatives instruments that got us into this mess in the first place. Then, they pocketed hundreds of billions in profits along the way. I’ve been writing about derivatives for years, and these weapons of mass financial destruction finally succeeded in popping the bubble that was the US economy. The con was so great that it took the rest of the world with it.

The top executives from these failed companies (Bear Stearns, AIG, Lehman, etc) had NO skin in the game. Collectively they owned less than 1% of the outstanding shares in their firms… so they had absolutely nothing to lose. All they had to do was get legislation passed that would allow the investment and banking industries to use leverage of 40 to 1 (up from the already obscenely large norm of 10 to 1), and along with the creation of financial derivatives that had little to no backing they engineered record profits out of thin air…which in turn allowed them to be compensated with billions upon billions in obscene bonuses. All while Rome burned.

So, the real question is; how is it that none of these con artists are getting their perp walk?? Maybe that day will come but holding our breath will likely be an exercise in futility. Chalk it up as another “accident” under George Bush’s reign of fire.

Why This $50 Billion Matters

Following a 50% drop in the stock market, everything was in place for a big bear market rally. Obama got elected, the government bailout put a stop to the run on the banks, and they even managed to put off the bankruptcy of the Big 3 until sometime in 2009. With extreme levels of pessimism, over $3 trillion in money market funds, and t-bills paying a negative return to investors, we should be in the middle of a recovery to at least 10,000 on the Dow. That’s still a long way from 14,500, but it would also represent a 30% move from the lows of just one month ago.

Then…Bernie Madoff happened… and it’s most likely time to say goodbye to any possibility of an extended bear market rally. This ponzi scheme has big money investors all over the world aggressively pulling money from money managers and hedge funds, and the result will be massive pressure on US and global stock markets as we head into the New Year. No one trusts anyone, and the financial world will never be the same as a result. Before this bear market is all over I predict that 70% of all hedge funds will be out of business and with it, another $1 trillion pulled from equity investments. This money will continue its flight to safety which will keep interest rates on government bonds at record low yields…until this bubble bursts as well.

Unfortunately for the FED, this will increase the deflationary environment that we’re in, and prices on all types of assets will remain under great pressure. Oil and gas prices are being decimated, and along with it the 30-40% of the earnings of the S&P 500. Each year of this decade has seen the index rebalanced to favor energy companies, and the result will be devastating for corporate earnings and for the major indices. In 2009 I continue to look for earnings on the S&P 500 to come in under $40, which means that even at current prices, the S&P 500 is trading with a P/E of 22. The really bad news here is that this is the level where bear markets begin rather than where bull markets get underway, so my forecast for 2009 is only getting more pessimistic. With a more reasonable P/E of 15, the Dow would have to trade down to 6500, or a 23% drop from today’s close of 8519.

Assume that we reach a bottom in earnings at the end of 2009, and we see a 20% earnings recovery in 2010. This means that we could see a recovery to approximately 7500 on the Dow in 2010. Unfortunately, this is what I see as a best case scenario.

The problem with this bear market is that the worst of the economy is in front of us, rather than behind us. The bad news from unemployment will continue to hit us for at least a year, and I continue to believe it will reach 12% before it’s all over.

The next shoe to drop will be in commercial real estate, and it won’t be pretty. After the first of the year we’ll begin to get the news of major tenants leaving malls and commercial properties in droves, and on the order that we haven’t seen in our lifetimes. Along with this, massive consumer debt will result in insolvent credit card companies, insurance providers and of course, collateralized auto loans.

The big mystery for most economists is exactly how much the next big fiscal stimulus package from Obama will help the economy. We already know that it will exceed $1 trillion, and along with his economic infrastructure and rebuilding program, the so-called experts are divided on how much it will really benefit the overall economy. My guess is that it will disappoint greatly and be widely viewed as a failure, but hey, he’s got to try something…right?

I say “wrong”. We’ve become the bailout nation and look how it’s working so far…

Our system needs purging, and the balloon needs to be allowed to burst naturally. This will allow us to get this over with once and for all. Will it be painful? Yes, it absolutely will, at least for those that have made terrible decisions with their money for decades, if not an entire lifetime. This is how a free market system is supposed to work, and unless we allow the process to play itself out, we will repeat the same mistakes that Japan has made for the last two decades as they have attempted to prop up failed banks and a broken/corrupt corporate system.

So, how has their economy and stock market done over this time frame? It’s not pretty. Japan’s stock market is down 78% from its high of 38,000 to about 8000 today. They have also experienced massive deflation, as evidenced by a real estate market that has dropped every single year for close to two decades.

Yet, for some reason we’re determined to use the same playbook. As Albert Einstein said, “Insanity is doing the same thing over and over again expecting a different result”. Massive government bailouts, printing our currency into oblivion, and passing down $100 trillion in debt to our kids…and to their kids…now that’s the definition of insanity.

Do we really think that capitalism can be saved by socialism?

Kip Herriage