Financial Armageddon

The Wall Street Clown Show

It's been a while since I laughed out loud while going through the news, but that's just what happened when I read the following Reuters report, "JPMorgan's Lee Sees S&P 500 Retest of '07 Record." As a service to loyal Financial Armageddon visitors, I thought I'd do them the favor by highlighting all the ridiculous bits:

The benchmark S&P 500 index should surge back to its October 2007 record above 1,500 by the end of 2012, provided the U.S. economy sees a V-shaped recovery, JPMorgan Chase Chief U.S. Equity Strategist Thomas Lee said on Wednesday.

My take: And I should be the next president of the United States, provided I have enough write-in votes when the 2012 election results are tallied. In reality, the notion of V-shaped recoveries -- especially after what we've been through -- is one of Wall Street's favorite (unfulfilled) fantasies. Otherwise, for reality-based insights on the impact of financial meltdowns, read "The Aftermath of Financial Crises," by professors Carmen Reinhart and Keneth Rogoff).

"The global economy is in the midst of a synchronized recovery," Lee said at the Reuters Investment Outlook Summit. "If we end up with a V-shaped recovery, we could go back to our record high of 1,500 in 2011-2012," he added, referring to the S&P 500.

The S&P 500 fell 0.4 percent to 908 on Wednesday.

My take: "Synchronized recovery"? Say what?! Not according to data published just weeks ago by economics professors Barry Eichengreen and Kevin O'Rourke, in a post at voxEU.org entitled, "A Tale of Two Depressions." Below is just one of their highly illuminating graphs (no sign of a rebound here, that's for sure):

Lee also reiterated his year-end 2009 target of 1,100 for the S&P 500, saying the United States will likely come out of its recession some time this summer, followed by the rest of the developed world.

In October 2007, the S&P 500 hit a record closing high of 1,565.15, before falling back. In March of this year, it slumped to a 12-year closing low, but has since rebounded by about 40 percent on hopes the recession that begun in December 2007 was moderating.

My take: In March 2008, Lee was counting on a "short recession," had penciled in a year-end price target of 1450 for the S&P 500, and was expecting "financials to lead the market higher," according to CNBC. So far, at least, there's no real sign that this allegedly "brief" downturn has ended, and anyone who bet on the JPMorgan "strategist's" prior call on U.S. equities managed to lose his or her shirt last year, because the broad market finished down 38% at 903.25, while the S&P Financials regurgitated more than half their value.

Lee added that a market correction in the wake of the recent run-up would be "healthy," and could lure back investors who opted to sit out the recent rally.

"This rally has left many investors uninvested or underinvested. The pullback is the entry point to really see more meaningful money put to work," said Lee, who has been named a top analyst in Institutional Investor magazine's annual all-star poll.

My take: not content to lead the lambs to the slaughter like he did last year, Lee is determined to fully eviscerate his followers without any real justification other than a reliance on the greater fool theory. Otherwise, in an interesting Freudian slip, Lee more-or-less acknowledges that the recent "green shoots" rally has not had much in the way of "meaningful money" behind it.

He favors the financials, industrials, technology and consumer discretionaries sectors, in that order, saying the sectors would be the biggest beneficiaries of an economic recovery.

Within financials, he favors asset managers.

The S&P financial index is up 84 percent since the broader market's 12-year low on March 9.

"We are still favoring cyclicals over defensives," said Lee. Even so, he was mindful of potential risks to the recovery.

"The biggest risk is that we're implicitly assuming the consumer is stabilizing. There's a lot of potential shocks. If oil goes to $100 a barrel, you can't have a recovery," said Lee, adding the other risk would be if savings rates somehow overshoot.

My take: even though reports clearly indicate that consumers are terrified about the future and are continuing to scale back, the housing market remains in the doldrums (or in the tank, depending on where you live), and personal consumption rates, savings rates, and debt levels are still on the wrong side of long-term averages, Mr. Lee assumes "the consumer is stabilizing." Why stop there? As long as we're talking BS, why not go a step further and "assume" that the consumer is flush with cash and starting to spend money like a drunken sailor?

One would have thought that after having been SOOOOO wrong about the events of the past two years, those who call themselves "strategists" would have sought out a more productive line of work.

Instead, all we keep seeing are endless reruns of the Wall Street Clown Show.

Stay tuned for plenty more?

Wall Street: Still Clueless

OK, it's official: Wall Street is still clueless as far as Main Street is concerned.

Otherwise, why would investors keep driving stocks higher in the face of the recent sharp rise in yields, which will make it that much harder for businesses to find their bearings in an already shaky economic environment?

Just as telling, why are investors buying shares in corporate America when corporate executives -- the individuals on the ground who actually know what is going on -- are on the other side of the trade, as the Pragmatic Capitalist reveals (below) in "Despite "Green Shoots" Insider Sales Spike"?

The latest data on insider selling shows little relief in the relentless unloading of company stock by corporate insiders.   In the last two weeks insiders sold over $335MM in stock vs listed insider purchases of just over $12MM.   As has been the trend over the course of the last few weeks the list of insider selling has been long and the amounts have been staggering.  The buy side, on the other hand, is represented by low rated, low priced stocks whose insiders rarely purchase over $500K.

One might think that with all of these “green shoots” the insiders at major U.S. corporations would begin buying up their own shares voraciously.  Especially after a nice little run like we’ve seen lately.  After all, with stocks still 35% off their highs and a full blown economic recovery (supposedly) on the horizon it would make nothing but sense than to buy your own shares, right?

Although there were signs of life in early May the overall trend in buying remains very low.  As we’ve noted before it’s not the mountain of selling that most concerns us, but the total lack of buying.  Insiders sell for many reasons, but they only buy their own stock when they are confident that the price will rise.  As of now, insider buying remains incredibly weak which is more than likely a vote of (no) confidence in future business operations.

Manipulation, Anyone?

Coming as it did on the last day of the week at the end of a month, some might find the action that took place near today's close to be rather interesting.

From 3:54:28 pm to 4:00:02 pm, S&P 500 e-mini futures rallied 17.25 points on approximate volume of 356,300 contracts, or 19.3% of the total turnover from 9:30 a.m. until futures finished trading at 4:15 p.m.

Hmmm. Manipulation, anyone?

New Reality Check

I've often noted that markets don't move in a straight line. Even during one of the worst bear markets in history, when the Dow lost around 90 percent of its value from 1929 through 1932, there were numerous double-digit percentage rallies along the way (see "Bear Market Rallies").

So, just in case you feel a sudden urge to join the permabulls, panicky short-sellers, serial bottom-callers, and greater fool investors who've helped drive the market up 25 percent since it hit oversold extremes in early March (aided, of course, by relentless Washington cheerleading and smoke-and-mirrors earnings announcements), below are (just) three reports that put a slightly different spin on this allegedly bullish new reality.

"Equities Still a Bubble and Equity Guys Out of This World, BNP Paribas Says" (FT Alphaville):

Yes, really. In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Moreover, they contend that equity analysts are “ignoring the tremendous value embedded in investment grade credit.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types (emphasis ours):
Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgement but P/E multiples of 30x certainly scream bubble to us.

As for the use of earnings yield, which they deplore as “another false measure”,

Equity analysts, using the operating earnings measure have also made the argument that earnings yield are significantly higher than 10-year US Treasury yields and hence equities offer value. This relative value comparison is fundamentally flawed on two counts. Firstly, as we have pointed out, operating earnings are not true earnings and secondly the relative value comparison, should be made to corporate bond yields not treasuries, which would be an appropriate apples to apples comparison. Using this measure, clearly it again illustrates the tremendous value in investment grade credit as opposed to equities.

And then there is the Goldman Sachs top:
Every bull and bear cycle is usually characterised by a significant event that anecdotally indicates over or under valuation in equities. The 2007 top was characterized by the generosity of Blackstone, which thought it fit to share its profits via an IPO, the equity piece of a highly leveraged entity and a known liquidity extractor.

The recent secondary offering by Goldman Sachs, could well mark the top of this bear market rally because GS, we believe would only issue equity at these valuations for two reasons, namely because it needed to as losses on its highly illiquid Level 3 assets continue to mount, or   because it saw its equity valuation as being grossly overpriced.

The lack of institutional participation and endorsement of this deal, radio silence from Mr. Buffett, who, as a consequence of this deal got diluted and with both Moody’s and S&P maintaining their Negative Outlook despite the equity injection, it points to GS being very opportunistic in exploiting its equity overvaluation and having the need to build a buffer for future losses.

Time will tell, how significant this GS top will be but for now it makes us very wary of equities, especially US financials, as they have become the playground of day-traders.

They also the purported green shoots in mortgage applications - “not a sign of new home purchases but simply refinancings”.

As for commodities and trade,

We will simply let the hard data and the charts do the talking here as commodities and the Baltic Dry index continue to show a “U” or “L” shaped recovery with no sign of “V”.

For the record, they’re expecting a “U” shaped recovery.

"Insider Selling Jumps to Highest Level Since 2007" (Bloomberg):

Executives and insiders at U.S. companies are taking advantage of the steepest stock market gains since 1938 to unload shares at the fastest pace since the start of the bear market.

Gap Inc.’s founding family sold $45 million of shares in the largest U.S. clothing retailer this month, according to Securities and Exchange Commission filings compiled by Bloomberg. Daniel Warmenhoven, the chief executive officer at NetApp Inc., liquidated the most stock of the storage-computer maker in more than six years. Sales by the co-founders of Bed Bath & Beyond Inc. were the highest since at least 2001.

While the Standard & Poor’s 500 Index climbed 26 percent from a 12-year low on March 9, CEOs, directors and senior officers at U.S. companies sold $353 million of equities this month, or 8.3 times more than they bought, data compiled by Washington Service, a Bethesda, Maryland-based research firm, show. That’s a warning sign because insiders usually have more information about their companies’ prospects than anyone else, according to William Stone at PNC Financial Services Group Inc.

“They should know more than outsiders would, so you could take it as a signal that there is something wrong if they’re selling,” said Stone, chief investment strategist at PNC’s wealth management unit, which oversees $110 billion in Philadelphia. “Whether it’s a sustainable rebound is still in question. I’d prefer they were buying.”

Insiders Sell

Insiders from New York Stock Exchange-listed companies sold $8.32 worth of stock for every dollar bought in the first three weeks of April, according to Washington Service, which analyzes stock transactions of corporate insiders for more than 500 institutional clients.

That’s the fastest rate of selling since October 2007, when U.S. stocks peaked and the 17-month bear market that wiped out more than half the market value of U.S. companies began. The $42.5 million in insider purchases through April 20 would represent the smallest amount for a full month since July 1992, data going back more than 20 years show. That drop preceded a 2.4 percent slide in the S&P 500 in August 1992.

The index rose 1 percent to 851.92 yesterday after better- than-estimated earnings at companies from Marriott International Inc. to ConocoPhillips and EBay Inc. overshadowed falling home sales and higher jobless claims.

Looking Forward

The S&P 500 has jumped 26 percent in 32 trading days through yesterday, the sharpest rally since 1938, on speculation the longest recession since World War II will soon end.

Stocks rebounded as President Barack Obama outlined a $787 billion package of spending and tax cuts to stimulate growth, the Treasury unveiled plans to finance as much as $1 trillion in purchases of banks’ distressed assets and the Federal Reserve pledged to buy more than $1 trillion of Treasuries and bonds backed by mortgages to drive down interest rates.

With corporate America stuck in its seventh straight quarter of earnings decreases, the longest in seven decades, executives may have become too cautious, said Penn Capital Management’s Eric Green.

Investors are looking to the final quarter of the year, when S&P 500 companies will increase operating income by 74 percent, according to analyst estimates compiled by Bloomberg. They forecast profits will fall 32 percent in the second quarter and 19 percent in the third.

“Things are a lot better than they were,” said Green, director of research at Penn Capital, which oversees $3 billion in Cherry Hill, New Jersey. Recent history also shows that “insiders have been wrong,” he said.

Confidence Game

Jeffrey Immelt, CEO of General Electric Co., purchased 50,000 shares at prices from $16.41 to $16.45 on Nov. 13, when the stock closed at $16.86. The shares have since fallen 30 percent after the Fairfield, Connecticut-based company reduced its dividend for the first time since 1938 and lost the AAA credit rating from S&P that it held for more than 50 years.

Insiders of consumer and technology companies have been selling the most stock relative to the amount they purchased this month, data compiled by Washington Service show.

John Fisher, Robert Fisher and William Fisher, whose parents Donald and Doris Fisher founded San Francisco-based Gap in 1969, sold a combined 2.99 million shares at between $15.11 and $15.36 a share on April 3 and April 17, SEC filings show. Gap rebounded 54 percent from its low on March 6. The stock gained 0.5 percent since the Fishers’ last sale.

Reasons to Sell

Gap spokesman Bill Chandler said that “from time to time, based upon the advice of financial advisers, the members of the Fisher family will decide to sell stock.”

Warren Eisenberg and Leonard Feinstein, who founded Union, New Jersey-based Bed Bath & Beyond in 1971, sold 1.05 million and 1.1 million shares at $30.90 apiece on April 9, the most since at least December 2001, the filings show.

The offerings came one day after Bed Bath & Beyond surged 24 percent, the biggest advance in nine years, on a smaller than estimated decline in fourth-quarter profit. Spokesman Ken Frankel said Eisenberg and Feinstein, who currently serve as co- chairmen of the largest U.S. home-furnishings retailer, sold for “estate-planning purposes and diversification.”

At NetApp, Warmenhoven sold 1.25 million shares, the most since at least 2002, for about $21.3 million between April 3 and April 21 at prices from $16.10 to $18.10 a share, the SEC filings show. Shares of the Sunnyvale, California-based company, up 47 percent from the March 9 stock market low of $12.52, gained 1.8 percent since then.

Moving On

Warmenhoven sold shares he received from exercising stock options that were due to expire next month, according to an e- mailed response by Lindsey Smith, a spokeswoman for NetApp. He reaped a profit of about $7.3 million selling the shares at an average price of $17.08 apiece, based on the conversion price of $11.25 for options he held, the data show.

“They’re going to say, ‘Thank you very much,’ and move on to cash or something else,” said David W. James, who helps manage about $2 billion at James Investment Research Inc. in Xenia, Ohio. “This is not a situation that suggests to us we’re seeing an economic recovery.”

"Bear Market Rally? Look at Gains & Volume" (The Big Picture):

In the light of today’s rally, perhaps it would be instructive to look at the volume on some past rallies. Fortunately, William Hester at Hussman Funds has done the heavy lifting for us, as these two charts show:

Changes in S&P 500 Leading to, and Coming Off of, Major Troughs

(Note: Data set = bear-market bottoms since 1940 )

Volume Changes From Major Bottoms

(Note: Data set = bear-market bottoms since 1940 )

Charts courtesy of Hussman Funds

Eventually, one of the Bear market rallies will be the one that is the turnaround. But until then, its guilty until proven innocent.

Equity-Bond Disconnect Redux

One of the regular features that Bloomberg provides to subscribers is its Chart of the Day column, which marries a graph produced using the functions available through the professional service with an article written by one of its editorial staff members.

In today's edition, "Bank Bondholders ‘Losing Faith’ as Shares Surge: Chart of Day" [no link available], columnist David Wilson highlights the divergence between equity and fixed-income markets, a disparity that I've often made reference to here at Financial Armageddon.

Shares of the largest U.S. banks have rebounded with a vengeance during the past four weeks. Their credit-default swaps haven’t kept pace.

The CHART OF THE DAY shows the disconnect between how Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. have fared in the stock market and how CDSs on their debt have performed.

Their share prices surged as much as 155 percent from March 10 through yesterday, as the top panel illustrates. The rally started after the Standard & Poor’s 500 Index set a 12-year low on March 9. Bank of America, Citigroup, JPMorgan and Wells Fargo all surpassed the S&P 500’s 20 percent gain during the period.

CDS rates for every bank except JPMorgan, on the other hand, were little changed yesterday from their March 9 readings. As shown in the bottom panel, they climbed in the second half of March, increasing the cost of insuring against debt defaults.

Bondholders “are losing faith in their ability to be made whole” in light of the U.S. government’s dealings with General Motors Corp., Peter Boockvar, a strategist at Miller Tabak & Co., wrote in an e-mail yesterday. When $1 billion of GM convertible notes mature June 1, the government won’t repay them, a person with knowledge of the discussions said yesterday.

“The bizarre thing is, if bondholders take haircuts, the stocks will go much lower,” he wrote in reference to the banks. So-called haircuts occur when borrowers pay back less than face value, leaving holders of their debt with losses.

Throughout the entire financial crisis, as regular visitors know, the credit markets have been consistently ahead of the curve. My guess is that this time won't be any different.

Nowhere Near a Bottom

People keep asking: Are we near the bottom in the stock market?

If history is any guide, the answer is no. That's because during similarly troubled times in the past, share prices did not hit their ultimate lows until traditional valuation measures such as P/E ratios and dividend yields reached oversold extremes.

For example, while the yield of the S&P 500 index is now at a multi-year high of 3.5%, it is still one-quarter to one-half the levels seen during the Great Depression, World War II, and the stagflation of the late-1970s.

Moreover, with payouts contracting, as Bloomberg notes in the following report, "Dividends Falling Means S&P 500 Is Still Expensive," that suggests there is much more downside to come before optimism might be warranted.

The fastest reduction in U.S. dividends since 1955 is depriving investors of the only thing that gave stocks an advantage over government bonds in the last century.

U.S. equities returned 6 percent a year on average since 1900, inflation-adjusted data compiled by the London Business School and Credit Suisse Group AG show. Take away dividends and the annual gain drops to 1.7 percent, compared with 2.1 percent for long-term Treasury bonds, according to the data.

A total of 288 companies cut or suspended payouts last quarter, the most since Standard & Poor’s records began 54 years ago, when Dwight D. Eisenhower was president. While the S&P 500 is trading at the lowest price relative to earnings since 1985 and all 10 Wall Street strategists tracked by Bloomberg forecast a rally this year, predictions based on dividends show shares are overvalued by as much as 46 percent.

“It’s a greater fool theory if we always buy stocks based on earnings and we never get a penny out of it, hoping for someone to buy that stock at a higher price,” said James Swanson, chief investment strategist at MFS Investment Management in Boston, which oversees $134 billion. “Dividends have been a cushion in bad times. If they go to zero it’s a disaster.”

Twenty-five companies in the S&P 500 saved almost $17 billion by cutting or suspending outlays this year, more than all the reductions from 2003 to 2007, when the index returned 83 percent. On a per-share basis, S&P 500 companies may trim payouts 13 percent this year, the biggest drop since 1942, S&P data show.

New York Times

New York Times Co., the third-largest U.S. newspaper publisher, suspended its 6-cent dividend after making steady payments since going public 40 years ago, to lower debt. Midland, Michigan-based Dow Chemical Co., the biggest U.S. chemical maker, cut payouts for the first time since 1912. Milwaukee-based Harley-Davidson Inc., the motorcycle maker, reduced its dividend 70 percent, ending a string of increases dating to at least 1993.

Futures on the S&P 500 climbed 1.5 percent at 10:44 a.m. in London on speculation that the U.S. government will increase its control of New York-based Citigroup Inc. The S&P 500 has lost 51 percent from a record reached in October 2007.

The same model that signals the S&P 500 is too high shows some companies that maintained dividends are cheap after more than $1 trillion in losses and writedowns at the world’s biggest financial institutions sent the U.S., Europe and Japan into the first simultaneous recessions since World War II.

McDonald’s Corp., the world’s biggest restaurant chain, Procter & Gamble Co., the largest consumer products maker, and eight other S&P 500 companies are the most attractive because they have cash to raise payouts, data compiled by Bloomberg show.

‘More Teeth’

Dividends are “the single best tool to understanding a company,” said Matthew McCormick, a money manager at Cincinnati- based Bahl & Gaynor Investment Counsel Inc., which oversees $2.5 billion and owns shares of McDonald’s and P&G. “There’s a lot more teeth to a dividend.”

Without dividends, investing in equities may not be worth the risk. Dividend income accounted for about 70 percent of average U.S. equity returns since 1900 after inflation, according to Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School, in a study published by Zurich-based Credit Suisse this month.

Investors who put $1 in U.S. stocks at the start of the century were paid back $582 with reinvested dividends, adjusted for inflation, the study showed. Price increases alone would have given an investor just $6 after that span, less than the $9.90 from holding long-term government debt, according to the study.

Cash Flow

“Ultimately, what you get out of investing in stocks is the cash flow from dividends,” said Laurence Booth, finance professor at University of Toronto’s Rotman School of Management and a colleague of Myron J. Gordon, who developed the constant growth version of the so-called dividend discount model in 1959.

The measure, which values a stock as the sum of all its future dividends, shows equities are still overpriced. With S&P 500 companies projected to pay a combined $25.27 in dividends this year, the index would need to fall to 526.46 before investors are compensated for owning shares.

The analysis assumes investors expect total returns of 6 percent annually from stocks, including a 1.2 percent increase in dividends, which is the historical average since 1900, adjusted for inflation, according to data from the London Business School.

2008 Slump

The S&P 500 closed last week at 770.05, after dropping 15 percent so far this year and 38 percent in 2008. Treasury notes and bonds of all maturities returned 14 percent last year, according to data compiled by Merrill Lynch & Co.

“Bearing in mind the higher risk, equities obviously become less attractive if the dividend decreases,” said Jörg Boysen, who manages a global equities fund at Frankfurt-based Union Investment, which oversees $182 billion.

Companies raising payouts may become more valuable. Oak Brook, Illinois-based McDonald’s, which returned 8.6 percent during the worst year for U.S. stocks since 1937, is undervalued by 46 percent from last week’s closing price of $54.57, according to a dividend discount model that adjusts for earnings and dividend growth over time.

The company, which boosted its payout every year since 1976, is set to pay $2.17 a share in 2009. That represents an increase of 34 percent from $1.625 last year, according to data compiled by Bloomberg. Spokeswoman Heidi Barker declined to comment on the future of the company’s dividend policy.

‘We’re Confident’

P&G, located in Cincinnati, is worth 42 percent more than its market price of $50.25, according to the measure. Analysts estimate the company, which makes everything from Tide laundry detergent to Charmin toilet paper and has increased its dividend for 52 consecutive years, will give investors $1.625 a share this fiscal year, a 12 percent increase from a year ago.

“We’re confident we can sustain strong dividends,” P&G Chief Executive Officer A.G. Lafley said at an analyst conference in Boca Raton, Florida on Feb. 19.

During the first half of the 20th century, dividend income made up all of the 5.3 percent return U.S. stocks delivered to investors, data compiled by the London Business School show.

At the time, companies paid out most of their earnings to shareholders, compelled by a Treasury Department rule that established penalties for “improper accumulation” of income, according to the sixth edition of Benjamin Graham and David L. Dodd’s “Security Analysis.” The book laid out the principles of value investing followed by billionaire Warren Buffett, the chief executive officer of Berkshire Hathaway Inc. and the world’s most successful investor.

“The prime purpose of a business corporation is to pay dividends to its owners,” Graham and Dodd wrote.

Market History

Between 1980 and 2000, investors increasingly sought price gains as dividends contributed 25 percent of returns. The shift occurred as companies such as Cisco Systems Inc. and WorldCom Inc. increased profits by using excess cash for expansion and acquisitions. In the five-year bull market that ended in 2007, cash to shareholders as a percentage of earnings fell to a record low of 31 percent, based on data compiled by Yale University professor Robert Shiller, as profit growth juiced by borrowed money outstripped dividend increases.

Returning money to shareholders prevents managers from wasting it on investments that may not prove profitable, according to Bahl & Gaynor’s McCormick.

“It forces companies from empire building, stupid acquisitions and nefarious activities,” he said. “You can’t fake the cash."

'The Biggest Story of the Year'

According to RealMoney.com columnist Doug Kass, general partner and investment manager of hedge fund Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd., today's late-breaking report of an alleged massive fraud at a well known investment firm could be "the biggest story of the year." In his view,

it is bigger than Enron, bigger than Boesky and bigger than Tyco.
It attacks at the core of investor confidence -- because, if true, and this could happen ... investors might think that almost anything imaginable could happen to the money they have entrusted to their fudiciaries.

Here is the Bloomberg report, entitled "Madoff Charged in $50 Billion Fraud at Advisory Firm":

Bernard Madoff, founder and president of Bernard Madoff Investment Securities, a market-maker for hedge funds and banks, was charged by federal prosecutors in a $50 billion fraud at his advisory business.

Madoff, 70, was arrested today at 8:30 a.m. by the FBI and appeared before U.S. Magistrate Judge Douglas Eaton in Manhattan federal court. Charged in a criminal complaint with a single count of securities fraud, he was granted release on a $10 million bond guaranteed by his wife and secured by his apartment. Madoff’s wife was present in the courtroom.

"It’s all just one big lie," Madoff told his employees on Dec. 10, according to a statement by prosecutors. The firm, Madoff allegedly said, is "basically, a giant Ponzi scheme." He was also sued by the Securities and Exchange Commission.

Madoff’s New York-based firm was the 23rd largest market maker on Nasdaq in October, handling a daily average of about 50 million shares a day, exchange data show. The firm specialized in handling orders from online brokers in some of the largest U.S. companies, including General Electric Co. and Citigroup Inc.

"He’s one of the pioneers of modern Wall Street," said James Angel, an associate business professor at Georgetown University in Washington. Madoff’s firm was among the first to automate market-making, in which a dealer continually buys and sells stock. The company was among the largest to offer "payment for order flow," or paying to handle customer orders.

The Practice

"The exchanges didn’t like the practice and questioned whether customers got the best price," Angel said.

Madoff started his firm in 1960 with $5,000 of savings and took advantage of securities-law changes in the 1970s designed to spur competition in U.S. stock markets, according to a profile posted on the Web site Finance Tech.

He was chief of the Securities Industry Association’s trading committee in the 1990s and earlier this decade, where he represented brokerage firms in discussions with regulators about new stock-market rules as electronic-trading systems and networks gained prominence.

"Bernard Madoff is a longstanding leader in the financial services industry," said defense lawyer Dan Horwitz. "We will fight to get through this unfortunate set of events. He’s a person of integrity."

SEC Complaint

The SEC in its complaint, also filed today in Manhattan federal court, accused Madoff of a "multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm."

The SEC said it’s seeking emergency relief for investors, including an asset freeze and the appointment of a receiver for the firm. Ira Sorkin, another defense lawyer for Madoff, couldn’t be immediately reached for comment.

As he was led from the courtroom to the clerk’s office to sign his bond, Madoff shook his head and said "no" when asked if he wanted to comment.

Madoff, who owned more than 75 percent of his firm, and his brother Peter are the only two individuals listed on regulatory records as "direct owners and executive officers."

Peter Madoff was a board member of the St. Louis brokerage firm A.G. Edwards Inc. from 2001 through last year, when it was sold to Wachovia Corp.

$17.1 Billion

The Madoff firm had about $17.1 billion in assets under management as of Nov. 17, according to NASD records. At least 50 percent of its clients were hedge funds, and others included banks and wealthy individuals, according to the records.

Madoff served as vice chairman of the National Association of Securities Dealers, a member of its board of governors, and chairman of its New York region, according to the SEC Web site. He was also a member of NASDAQ Stock Market’s board of governors and its executive committee and served as chairman of its trading committee.

Madoff’s Web site advertises the "high ethical standards" of the firm.

"In an era of faceless organizations owned by other equally faceless organizations, Bernard L. Madoff Investment Securities LLC harks back to an earlier era in the financial world: The owner’s name is on the door," according to the Web site. "Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm’s hallmark."

Nominating Committee

Maddoff is a member of Nasdaq’s board nominating committee. He was an early advocate for electronic trading, participating in roundtable discussions at the SEC as regulators weighed trading stocks in penny increments. His firm was among the first to make markets in New York Stock Exchange listed stocks outside of the Big Board, relying instead on Nasdaq.

"These guys were one of the original, if not the original, third market makers," said Joseph Saluzzi, the co-head of equity trading at Themis Trading LLC in Chatham, New Jersey. "They had a great business and they were good with their clients. They were around for a long time. He’s a well-respected guy in the industry."

The case is U.S. v. Madoff, 08-MAG-02735, U.S. District Court for the Southern District of New York (Manhattan)

And here is the SEC press release:

SEC Charges Bernard L. Madoff for Multi-Billion Dollar Ponzi Scheme
FOR IMMEDIATE RELEASE

2008-293

Washington, D.C., Dec. 11, 2008 — The Securities and Exchange Commission today charged Bernard L. Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm. The SEC is seeking emergency relief for investors, including an asset freeze and the appointment of a receiver for the firm.

The SEC's complaint, filed in federal court in Manhattan, alleges that Madoff yesterday informed two senior employees that his investment advisory business was a fraud. Madoff told these employees that he was "finished," that he had "absolutely nothing," that "it's all just one big lie," and that it was "basically, a giant Ponzi scheme." The senior employees understood him to be saying that he had for years been paying returns to certain investors out of the principal received from other, different investors. Madoff admitted in this conversation that the firm was insolvent and had been for years, and that he estimated the losses from this fraud were at least $50 billion.

"We are alleging a massive fraud — both in terms of scope and duration," said Linda Chatman Thomsen, Director of the SEC's Division of Enforcement. "We are moving quickly and decisively to stop the fraud and protect remaining assets for investors, and we are working closely with the criminal authorities to hold Mr. Madoff accountable."

Andrew M. Calamari, Associate Director of Enforcement in the SEC's New York Regional Office, added, "Our complaint alleges a stunning fraud that appears to be of epic proportions."

According to regulatory filings, the Madoff firm had more than $17 billion in assets under management as of the beginning of 2008. It appears that virtually all assets of the advisory business are missing.

Madoff founded the firm in 1960 and has been a prominent member of the securities industry throughout his career. Madoff served as vice chairman of the NASD, a member of its board of governors, and chairman of its New York region. He was also a member of NASDAQ Stock Market's board of governors and its executive committee and served as chairman of its trading committee.

The complaint charges the defendants with violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940. In addition to emergency and interim relief, the SEC seeks a final judgment permanently enjoining the defendants from future violations of the antifraud provisions of the federal securities laws and ordering them to pay financial penalties and disgorgement of ill-gotten gains with prejudgment interest.

The SEC's investigation is continuing.

The SEC acknowledges the assistance of the U.S. Attorney's Office for the Southern District of New York.

# # #

Just a Passing Bull

It's been said that markets do whatever is necessary to hurt the most people.

That is why prices sometimes shoot higher when news flow, investor sentiment and speculative positions are skewed to the negative, and why rampant euphoria is occasionally the set-up for a violent correction.

With that in mind, I still believe the path of least resistance for the equity market over the next month or two is up, in large part because bad news and increasing volatility have so many people worrying and thinking -- and betting -- otherwise.

Even so, I wouldn't view any rebound in the near term as anything more than a passing bull.

Among other things, the many imbalances and excesses that built up during the past several decades suggest that, as far as the financial system, the economy, and corporate America are concerned, there are still plenty of shoes left to drop.

That also means share prices have lots of room left on the downside.

Still, for those who think I've got it wrong about the broader outlook, they might want to keep an eye on what is happening in another key financial arena.

As the Financial Times' Tony Jackson notes in "Time to Pay Closer Attention to the Credit Markets," the fixed-income markets have been at the leading edge of the Great Unraveling since the outset.

Investors have had it drummed into them that the biggest one-day percentage rises in the history of the Dow were sucker’s rallies in the great crash of 1929-33. The message: this is no time to trust rallies.

The second lesson is less obvious but equally important. Equity investors should pay more attention to the credit markets.

While world equities were surging more than 20 per cent recently, credit strategists were incredulous. What was there to be cheerful about?

It was all too reminiscent of last summer, when the broad equity indices in the US and UK hit all-time highs just as the credit crisis was beginning to blossom. Credit specialists thought that was crazy and they were dead right.

Equity bulls argue the market is a discounting mechanism, which looks across the valley to the sunny uplands. But the credit markets are discounting mechanisms too. And, as Suki Mann of Société Générale puts it, the question is when to start discounting.

Granted, some signs from the credit world have been ostensibly encouraging. Libor rates have dropped to levels that, though still abnormal, are lower than before the Lehman Brothers collapse. And in the US – though not in Europe – the commercial paper market is starting to function again.

But these are both the result of direct government intervention. When it comes to new issues in the bond market, there are far fewer signs of life.

This is crucial. There have not been many equity rights issues either. But equity is permanent capital that, unlike bonds and bank debt, does not have to be constantly replaced. And while it is helpful that US companies can now roll over their short-term commercial paper, refinancing longer-term debt is still cripplingly expensive.

Last week, Altria, the US tobacco company, issued bonds at 600 basis points over Treasuries, for a yield of almost 10 per cent. Yet this is a company with no net debt and the abnormally stable cash flow that comes from having addicted customers.

Granted, the spread on credit derivatives has narrowed. But cash bonds have not followed suit. The so-called basis – the difference between cash and derivatives spreads – has widened enormously. Unlike derivatives, cash bonds these days are illiquid. So a liquidity spread must be added to the default premium.

If the bond market is not working, neither is the banking system. Three weeks ago, for instance, I wrote about how the plunge in dry bulk shipping rates – the Baltic Dry Index – resulted partly from banks refusing to issue letters of credit.

The International Group of Treasury Associations – representing corporate treasurers – has since gone public on the issue. World trade, it says, is “freezing up”. And the problem, yet again, is that the banks do not trust each other.

This is because, when a company in one country is shipping goods to a customer in another, the buyer’s bank is supposed to supply a letter of credit to the seller’s bank so the shipper can get paid promptly. These days, it seems, no deal.

But to revert to the main topic. Why are credit analysts – in Europe especially – still pessimistic?

Partly because they are still waiting for the storm to break. Equity investors are now seeing the reality of corporate earnings falling, even if they seem curiously surprised by it. Credit markets, by contrast, are braced for defaults to start soaring, but the default rate is still very low.

It is, in other words, a trailing indicator. Mr Mann reckons it might not peak until 2010 – and that spreads ought not to peak until shortly before that.

This illustrates a basic problem. Some two-and-a-half years ago, I wrote about how equity and credit analysis seemed to be coming together. Analysts in those two very different disciplines were swapping ideas and information to reach a more sophisticated view of a company’s prospects.

However true that was then, it is certainly not now. One reason is that the pioneers of this approach were the hedge funds, in search of profitable anomalies.

These days the hedge funds have more brutal priorities, such as raising cash to meet redemptions. And the fundamentals are now so disregarded, in equities especially, that there is no guarantee that anomalies will not simply get worse.

Last week in this paper, the global head of institutional investment at Fidelity International urged equity analysts to drop their fixation with earnings and spend more time on cash flow and capital structures. As things stand, he is unlikely to get his way soon.

But in the meantime, remember the lesson. This is still first and foremost a credit crisis. If the equity and credit markets disagree, go with credit.

Halloween Must-Have?

Given the scary moves that share prices have been making lately, the following get-up may well turn out to be this year's "must-have" Halloween costume...

Costly Advice

I spend a lot of time harping on about the cluelessness of the "experts" who've consistently misled the public or completely missed the boat about the worst financial crisis since the Great Depression (which has been correctly anticipated at Financial Armageddon and in my book of the same name since early last year).

That isn't to say that I haven't made plenty of mistakes and bad calls through the years -- I have. But at least I've tried to learn from them and am aware that even after having been around the traps for a while, I still have plenty to learn. Indeed, when contacts ask me what I think about the stock market, for example, I often preface my response -- which is nothing more than an honest guess -- with the assertion that I could be wrong.

However, there are many others running around nowadays who seem to deny the reality of their own fallibility or who sputter self-serving or ignorant nonsense that can cost naive readers and listeners a bundle of money if the "advice" they are offering is taken at face value.

In fairness, some would say that those who act on the words of others without doing their own due diligence deserve what they get. However, I believe the mainstream media shares part of the blame because they do little to dissuade their audience from believing that those being quoted or referenced have been properly vetted.

More often than not, it seems, the "validation" process is something of a sham. What forms the basis of the designation as a recognized "expert" are self-reported "facts," corporate affiliations, academic "credentials," and --especially -- the ability to communicate well.

Unfortunately, that means at least some of those who get a lot of ink or airtime -- and attract the most consistent attention from those who are paid to report on what is going on -- don't necessarily reach that point because of the inherent value of what they have to say. Instead, they are providing entertainment or some kind of psychological assuagement.

Based on the following overview from Gawker, "Jim Cramer's Erratic Year," one can guess how I feel about the supposed credibility and near hero-worship afforded to one particular financial expert:

Jim Cramer has changed his mind! Just last week, you may recall, the shouty CNBC stock picker appeared close to tears as he begged Americans to pull all the cash they'd need for the next five years out of the crippled stock market. Well, whatever, that was last week. Now he says that we've already reached "the beginning of the end of the crisis." That sure was fast! This, of course, is in line with his (physical and intellectual) penchant for wild gesticulation. Let's take a brief look back at Mr. Cramer's unpredictable recent past, shall we?

• August, 2007: God damn Bernanke! Alan Greenspan! They have no idea how bad things are. No idea! (Wild rage).
• September, 2007: "The only thing I have is my authenticity."
• January, 2008: Cramer predicts Mike Bloomberg might buy the New York Times. Not yet!
• January, 2008: Cramer bet that financial stocks would outperform other sectors in 07. Lost bet.
• February, 2008: Barron's points out that Cramer's stock picks suck, factually speaking. Barron's reporters are banned from CNBC.
• March, 2008: Cramer nearly cries on TV because he was surprised Eliot Spitzer likes sex so much.
• March, 2008: Cramer tries to save Bear Stearns. Turns out he's not that influential.
• September, 2008: Jim Cramer was totally right in his initial crazy rant against Bernanke! Unfortunately he screamed so many things subsequently that everyone had forgotten about it by the time the markets crashed.
• October, 2008: But um, Cramer also recommended Wachovia stock as a "safe haven" for investors. That was very, very wrong.
• October, 2008: He got so upset he said f*ck it, just put all your money under the mattress!
• October, 2008: Okay, back to normal!