A Year-End Synopsis and a Not-So-Close Call with
Mr. Ponzi.
We are approaching the end of 2008 so it’s time to look back and make sense of what happened. It is also time to look ahead to possible opportunities on the horizon.
Before I begin, however, I want to relate a personal experience to you that has become news this week. In 2000, I received a call from someone looking for help in investing a friend’s money. Then, like now, the market was declining and his friend had experienced some significant losses. I took the portfolio and fashioned it, as usual, for growth and asset preservation.
The person referring his friend was using a money manager that showed consistent returns year in and year out. I’m talking 10% returns, no matter which way the market was moving. Every year his portfolio would rise by about 10% with never a down year. I knew this couldn’t be true, so I asked for the statements and trading reports to see what was going on. I spent the good part of the week studying the material, but couldn’t find anything suspicious. The manager was trading in and out of positions on very specific days, making regular profits but there was nothing incriminating on the reports.
This manager, by the way, was very well known on Wall Street as a major Market Maker for many important stocks. A market maker is a company whose function is to aid in the market, by making bids and offers for his own account in the absence of public buy or sell orders. In other words, it’s a company that is very involved in the order flow from investors around the world. I chalked his performance up to the fact that he was so involved; he could get in between the flow of buy and sell orders.
Of course, I couldn’t come anywhere close to these types of smooth consistent returns and eventually the client left as he was able to convince this money manager to take his friend’s account.
Last week it was revealed that this manager’s name is Bernard Madoff and he is accused of running a $50 billion Ponzi scheme. This is the largest fraud I know of using a Ponzi or pyramid scheme. The scheme involves using new investors’ capital to give old investors a return on their investment. This pyramid works well until there are no new investors to entice, or old investors start asking for their money back. This seems to be exactly what happened. Investors, spooked by the market asked for $7 billion of their money back and the manager was unable to pay. Madoff confided to senior people ( his sons, apparently) that he had been running the Ponzi scheme for many years and he was broke. I heard about this from a CPA whose client has $12,000,000 in the fund. The CPA’s client was the person who had come to me 10 years ago. He lost it all, I understand.
I think you all know the lesson here. If it’s too good to be true then it’s probably a scam. I feel very bad for anyone involved in this type of scheme and any “I told you so’s” don’t help anyone, but I have seen this so many times in my years, that each time it happens I’m still surprised. These schemes ALWAYS lose in the end. They have to. It’s a law of financial physics. There is always a trade off. It’s important to note, if you are looking for higher returns and have placed your money in the stock market, real estate market, gold, currency, oil etc.; you are always assuming some risk. If the risk has been abated, then the return has to adjust as well. There is no free lunch.
Let’s continue with my commentary, and look at the numbers through December 12, 2008 For the month through December 11th, the Dow is down 2.99%. For the year, the Dow has decreased 35.43%.From the high reached on October 9th, 2007, the decline has been 39.53%. The S&P 500 has decreased 44.18%.
These are horrific numbers. It took the S&P almost 3 years to lose 40% between 2000 and 2002. This time it has taken less than one year. From the high on October 9th, 2007 to the low on 11/20/08 the market declined 52% which was the third worst ever. The number 1 and number 2 declines took place in 1932 and 1938, down 62% and 54%, respectively. There were 5 other declines greater than 40%, 4 took place in the 30’s and 1 in 1974.
Bespoke Investment Group, provided these numbers, and they feel we are now in a bull market, as hard as that is to imagine. They define a bull market as one in which there is a 20% rally after a 20% decline. They believe the bottom of the market was the November 9th, at the 7,500 level on the Dow.
Whether we are in a bull market or not, the technical reading for the market still shows no signs of an imminent recovery just around the corner.
Finally, are there any opportunities for high returns in 2009? The answer is yes, a few good ones are taking shape. Two are in the bond market and one is a complete surprise.
Bonds
The two opportunities in the bond market are associated with good quality and low quality corporate bonds.
Normally, to measure corporate bonds’ risk/reward, you look at the difference in the yields as compared to treasuries. This difference or spread is currently well above normal due to the credit crisis. A normal spread is 2-3%, today the spread is 5-7%. This means you are getting paid a lot of money for the risk you are taking.
High Yield bonds are yielding even more. The spread between “junk” bonds and treasury bonds is at a historic high of 12%; i.e. high yield bonds are currently paying 15 to 20% while treasuries are at 2.5%. This spread pays you very handsomely for the risk you are taking.
Now the surprise. An asset class that is currently undervalued is Real Estate. As a matter of fact, the shares of home builders have increased 30% from their November 20th lows, so something is going on here. Real Estate Investment Trusts, which invest in all types of Real Estate, from residential to commercial properties are now paying dividends of 6-9%, as investors worry about office building vacancies in 2009. It is obvious that commercial real estate is under pressure from the slowing economy, but once again, you may be getting paid for the risk. There is no hurry to act on any of these items so I will be buying these investments discriminately as the opportunity arises.






Fratricide? Patricide? Genocide?
Investicide
Somewhere among the moneyed elite, you may have heard the following conversations:
“I hear you want to invest in the fund, so tell me about yourself (Let me see if you are worthy)
Where do you live? Oh, there? Check.
Gobs of money, Check., (nice Bentley in the driveway, by the way).
Charitably inclined, Check.
Okay, so who do you know? No kidding…Check.
Well, I’ll tell you what. You got a million to invest? Why don’t you start with $200,000 and we’ll go from there. See if we get along, okay? Yes, yes, yes, you’re welcome–don’t mention it. I’m happy to do a favor for one of our kind.”
From all accounts, these were the conversations going on in exclusive hotels and country clubs around the world. The person talking is Bernard Madoff (Bernie to his friends) and his minions. This is a small part of the story that is unfolding as the days pass by. The story of the largest Ponzi scheme in history. $50 billion dollars of history.
It is said that Steven Spielberg was an investor with Madoff. It would seem that he had a close encounter of the 3rd kind, which, by definition, is direct contact. I, on the other hand, had a close encounter of the 1st kind, which is a sighting of odd lights and objects not attributable to human technology. My sighting came 10 years ago, when a CPA asked me to comment and review the returns of a very successful money manager. One of his clients was very excited by the possibility of investing with this manager. What bothered the CPA and subsequently bothered me, was the questionable consistency of the returns. Records showed gains of 10-15% per year; year in and year out. Not a single year of negative returns. I looked over the material and stated bluntly that this was not possible, and I advised him to pass on this. Luckily, he did.
This, for me, was a simple observation. I had never seen or heard of anyone who could invest like this, and having read many books about the world’s greatest investors, I knew the basic rules of the stock market, one of which can be explained by the following metaphor: “If you’re in a boat, and the boat is in the water, when the tide goes out, you have to go out with it”. In other words, if you are invested in the Stock Market, it is impossible to get in and out of the market consistently and successfully over any long period of time. Because of the laws of financial physics, it is impossible. Like gravity, what goes up must come down.
How did so many people get fooled? Everyone is asking themselves the same question. How could so many people entrust their entire savings to one person? Even a few professionals were fooled and they should have known better. Professionals know how to diversify appropriately. They know that one manager, even with very good investment results; will lose money at some time. It takes a well diversified portfolio to protect you from this fact. Diversification prevents these types of devastating events. Interestingly, Madoff made no pretentions to diversification. He had one strategy, and that was his secret. It is reported that he freely told investors that he would reveal how he invested the money and it seemed a matter of pride. No one could do it like him and because he did it for so long, everyone believed him.
What can we learn from this? Madoff’s strategy could have been considered hypnotic. According to Laurence Leamer, author of “Madness Under the Royal Palms”; if Madoff handled your account, you could boast about having the largest financial gains to your friends. It was an honor if Madoff managed your money. He had the Midas touch. Madoff was a God.
How did he succeed for so long? How did he pull this off? To answer this, let’s examine the psychological reasons he succeeded. I’m not a psychologist, but I have my own ideas.
First, he was smart enough not to publish or pretend he had made the highest returns. If his fund was rising 28% per year for 10 years everyone would have been suspicious. He just promised 10%, a very reasonable return. After all, hasn’t the stock market risen at an average rate of 10% for the last 80 years? Most people don’t realize that the term: “average return of 10%” is very misleading. Here’s why. It is said, “If you have your head in the freezer and your feet in the oven, you’re average temperature is 98.6 –but you’re dead”. Or “The average temperature in Dallas, Texas is 78 degrees, but it’s 110 in the summer and 25 in the winter”. You see, it’s misleading. Some years the market can rise by 10 and 20% and in other years it may fall by 30%. The average may be 10%, but the sequence of these returns can really hurt you if you’re not prepared. Madoff’s trick was to use consistency as his lure. This is an old sales technique called the “Puppy Dog “close and I want to thank my friend Bob Irish for this one.
The “Puppy Dog “close is used by pet stores to “help” you make a decision to buy a puppy while you’re already in the store. The salesperson knows the decision to buy a dog is a big one. It’s a big commitment to care for a puppy for many years, and it may give you pause. To make the decision easier, the salesperson breaks the purchase down into smaller increments. This allows you to make a small decision instead of a large one. Instead of just buying the puppy, the salesperson suggests you just take it home for a little while and if you don’t like it, bring it back. He knows that once this dog licks your face and starts playing with you, you’re probably NOT bringing the dog back! It’s the “Puppy Dog” close.
Once Madoff’s new investors became involved and got a taste for those steady returns, they were not going back!
Madoff’s club was an exclusive club. You may remember how it felt to be excluded from cliques in high school and how good it always feels to be a part of something special. That is how it felt to invest with Madoff. You were a part of something special. If you had Madoff, you were special. Investors didn’t investigate Madoff before they invested, he investigated you! What a brilliant switch!
He took advantage of our love of celebrity culture. We love and admire our celebrities and endow them with major powers and gifts of insight. If it was good enough for Steven Spielberg, it’s surely good enough for me. Steven Spielberg is a movie making genius, but does that make him a savvy investor?
Finally, Madoff was using what is now referred to as viral marketing. This is the same as word of mouth, only stronger. Viral marketing is a technique that uses pre-existing social networks to produce increases in brand awareness. You know, you tell two friends and they tell two friends etc. This is very powerful stuff and very hard to resist.
So what should you do if you are presented with one of these too-good-to-be-true investment schemes?
Use your good sense. YOU do the due diligence–it’s your money. Do your homework. Don’t take someone else’s word for it. Try to keep your emotions out of it, and remember Groucho Marx’ famous saying: “I won’t belong to any club that would have me as a member”.
If you give your money to a manager, make sure he is not holding the money in his own brokerage account, or that your money is not comingled with others unless it is a registered security. If it’s not registered, have a securities attorney look over the documents. Also, it is preferable that the money sit at an independent firm, a firm that is separate from the manager.
Finally, know what you own. Look for diversification. Diversification will protect you from a lot of serious mistakes made by investors. Stay vigilant. You have worked very hard for your money, so make sure the person managing it, respects it as much as you do.
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