W.I.L. Finance Digest for Week of December 22, 2008

CONFIDENCE AND MADOFF

We are stuck with a great big Bernard Madoff called the U.S. government. He calls himself Uncle Sam and tries to establish a friendly relationship with us. Confidence in him is unwarranted. Beware.

Credit is based on confidence. Robert Prechtor never tires of pointing out that human herding behavior leads to ebbs and flows in the collective level of confidence, which will impact the willingness of people to take on or extend credit.

To us the story of Bernard Madoff's now revealed massive con game is as much a story of the bull market which commenced in 1982 as it is one of a massive institutional and individual breakdown in due diligence. Too few people would have believed Madoff's claims in the 1970s for the scheme to have gotten going. The ground was infertile. Once the bull market took off the seeds of credulity found sustenance. They in turn provided sufficient fuel to perpetuate Madoff's nefarious plan once it got started. But when aggregate confidence waned the fuel ran out. With the post-1982 bull market now wholly in the rearview mirror we expect more such frauds to be revealed. The question is when, as Michael Rozeff implicitly asks here, by far the biggest Ponzi scheme of all -- the U.S. government funding system -- collapses.

I was once defrauded of $5. I am glad. It was a very cheap lesson. It happened in the Soviet Union when my greed got the better of me. I thought I was buying roubles at a good rate on the black market. Instead, I was handed worthless Yugoslav notes that looked like roubles. My wife had told me not to buy them.

Thinking back, I had no reason to be confident in the trader who offered the notes to me at half the going rate. I wanted to buy some items from a booth nearby, and his offer was convenient and conveniently low. I was inexperienced. This was my first purchase. These are excuses. I was taken. He was well-dressed, glib, and persistent. I should have taken all that as a negative signal! Afterwards, he ran to a car. Few Russians had cars at the time.

People who lost to Bernard Madoff lost for many different reasons not hard to imagine. In one way or another, he gained their confidence. In an old video of Madoff, he smiles and steeples his fingers, which is a body language sign of confidence in oneself. It looks to me as if he enjoyed secretly playing his con(fidence) game and putting one over on people.

Confidence comes from two Latin words. The prefix "con" means with. The root "fid" suggests faith. Fides means faith. The mutual fund family "Fidelity" chose its name to suggest that the buyers may have confidence in the company. Fidelity is faithfulness to one's duties. High-fidelity is sound that is faithful to the original. Madoff broke faith with his customers.

Not everyone can be trusted. We especially cannot trust the federal government, which breaks its word continuously. Most of us, as individuals, cannot and do not control government. It has the power over us, so that we have virtually no incentive even to understand its words much less verify them. Hence, when government claims to regulate people like Madoff in order that we may deal with them in confidence and safety, we have no good reason to believe government. The fact that many of us believe what the government says means that government is successful at its confidence games.

People bought securities from Madoff. He misrepresented the risk and return of those claims by using cash inflows (new money) to create steady streams of cash outflows for earlier buyers (old money.) This is what a Ponzi scheme does. The verification process broke down or was overlooked by nearly everyone except Mr. Markopolos, whose persistence finally paid off.

Madoff issued bad credits and got away with it for a long time. Credit depends on confidence. Madoff won the confidence of investors. But credit does not depend on blind confidence. It is confidence born of concrete signs and signals. Investors with Madoff thought they had those signs and signals. They were deceived. Reagan is famous for saying "trust but verify." That is a wise and true saying, and in fact that is how we typically behave. When we stop verifying, we get into trouble.

There is no way to prevent more Madoffs from occurring because credit is inescapable in an exchange economy. The cost of preventing all frauds exceeds the benefits. The cost of the auditing and policing would be prohibitive.

We can make things better, however, by getting government out of the business of inspection, certification, and auditing. In that way, the cost of auditing and revealing frauds will drop dramatically. There will then be fewer frauds perpetrated. With government in the business of checking up on financial institutions, we are worse off.

In a free market, financial firms compete for investment dollars. They compete to provide transparency, that is, honest reporting of returns and risks. Fakes, phonies, and shysters are eliminated when they are found out. In a free market, the competing businesses have an incentive to police the competition and point out potential frauds. They may even hire detectives to check up on suspected shady enterprises. The amount of policing rises.

In a free market, there may arise private associations of firms that enforce strict inspections on the members to assure their reliability. They publish results and the members gain the confidence of the public. In that way, they get more business. Such associations already exist. But the state tends to preempt and weaken such possibilities. The state tends to replace private monitoring with its monitoring.

State inspection systems undermine the free market incentives to lower fraudulent behavior. It becomes in the interest of every financial firm merely to meet the minimum standard, not exceed it. The state's inspectors do not have strong incentives to search for and root out fraud. Else, why did the SEC take 8 years to come to grips with Madoff, after the warnings of Mr. Markopolos?

When the public comes to believe that a firm is acceptable because it has passed the government procedures, which members of the public do not verify as to their efficacy, then more frauds are possible. In a free market, the financial firms would actually compete to produce higher standards than their competitors, not minimum standards and the customers would have a higher incentive to monitor these firms. In the regulated market, firms and customers are lulled into passivity. Why? Any business effort to persuade people that it is clean and honest is penalized because the firm has to persuade the public that it is better than what they believe has been passed by the state as acceptable. If the people think that state monitoring is acceptable, then the business efforts to raise themselves above their rivals are less cost-effective.

The larger subject here is credit. There is always a chance that a credit risk will default. Such risks cannot be reduced to zero without incurring prohibitive costs.

Credit arises when one person accepts the issuance of a liability by another person. A liability is an obligation or claim on oneself that a person issues. It promises delivery of some good or asset in the future. Debt is a liability. A promise to pay is regarded by its recipient or the holder of the claim as an asset. That person has advanced credit. If Carl hands his car over to Bill, and Bill promises to make payments in the future to Carl, then Bill issues a liability and Carl holds that liability. Bill is the borrower and Carl is the lender. Bill's liability is Carl's asset.

But Carl cannot be sure that Bill will pay off the debt. No one can ever with complete certainty guarantee a cash flow (or a resource) will be available in the future. Even storing an asset or cash provides no certainty. All sorts of contingencies may intervene that prevent the promise from being fulfilled.

Madoff could not issue a security without the buyers expecting to gain something from their purchases. This follows directly from the action axiom of von Mises. A buyer expects to gain utility from a purchase. At the instant of purchase, utility should rise. This does not mean that the buyer is sure of the future payments. If he buys an uncertain stream of payments, he is sure that his valuation of them exceeds their cost. He could be mistaken. Madoff's buyers were mistaken.

What the buyer expects to gain is not specified in this statement. It is possible that a buyer gains utility from the act of purchase itself. For example, a buyer can gain utility from the act of purchase by feeling he is helping a worthy cause (buying war bonds) or from dealing with Madoff himself. Utility might come from receipt of the paper certificate itself.

When utility from these sources are not present, and usually they are not, then money return is the plausible source of utility or gain. It is the case in most instances, but the return can arrive in other forms, such as other securities, services, goods, coupons, tickets, etc.

A security buyer (who desires return) will not buy the security unless he knows something favorable about the ability and intent of the issuer to make the promised payments. In other words, the buyer who expects a return can only expect it if he expects that the seller will have the ability and intent to make the payments. And in the possible conditions of default, he has some expectations about enforcement and partial recovery.

The security buyer cannot form an expectation of gain without knowledge leading to belief and thus confidence that the gain will occur. In the case of debts, returns are impossible if the issuer has no current or future means to pay. Therefore, the buyer has to satisfy himself that this ability is present and will be maintained in the future or else he can form no expectation of gain. In the recent case of mortgage lenders who made non-fraudulent loans to non-fraudulent persons with sub-standard records of credit and income, the main assurance seemed to be the collateral (the house or dwelling) and the expectation that it would continue rising in price. In addition, other cases in which fraud was involved among buyers and sellers appeared.

The following are methods of learning to expect that a seller or issuer of a debt will make the promised payments. It is not intended to be an exhaustive list. It helps show that lenders do not build up confidence based on blind trust.

1. A buyer of a debt (a lender) may trust the seller (the borrower) to repay because he has a general knowledge of the seller's reputation and believes that the seller does not want to harm his reputation.
2. A lender might have personal knowledge of the borrower's behavior in the past. He may know that the borrower has repaid his debts in the past. A lender might gain information about the borrower's character, work habits, plans, capacities, etc.
3. A lender may expect a borrower to repay because the borrower has obtained the endorsement of a third party whom the lender trusts. The borrower may obtain a co-signer.
4. A borrower can transmit information about ability and intent to pay by depositing collateral with the lender. This provides knowledge of the ability and intent to repay since the collateral can be sold. If loss of the collateral is damaging to the borrower's business, then, even if the collateral is not sold, the potential harm to the borrower informs the lender that the borrower will try to honor the debt. The collateral may transmit the information that the borrower has in the past been able to accumulate a given level of resources. Collateral is a type of pre-paid conversion or redemption of the debt into cash.
5. A lender may directly investigate the income of the borrower or other characteristics associated with ability and intent to repay. A lender's knowledge of the borrower's ability to pay is aided by knowledge of a number of things. These include knowledge of the competing debts that the borrower has outstanding, because the security of one's claim depends on the timing and overall volume of all other claims. It helps to know about the business operations and income of the borrower, since these generate the cash flows to service the claims.
6. A borrower can transmit information so as to obtain funds by securing the security with assets. No collateral needs to be deposited, but the lender can have a call option on the assets in case of default. Otherwise the situation is similar to the case of collateral.
7. The ability to pay off debt can be measured by the borrower's wealth. When a firm that has a stock outstanding borrows, the market value of the equity measures the wealth that can be applied to paying off debt. Specifically, market value of equity per dollar of borrowing may be a useful number in assessing ability to repay debts.
8. The fact that a borrower has issued other debt claims transmits information, because some lenders are already endorsing the borrower's ability to pay the claims. The more important and highly regarded is the lender of the claim, the more impact that this may have on the perceptions of others. On the other hand, the prior issuance of debts is a double-edged sword, because the higher the issue volume, the more tenuous become the junior claims, other things equal.
9. Lenders attach strings to debtors, called debt covenants. Monthly payments are such a string. In the case of business firms, there are many, many covenants that limit the operations of the managers. The lender may preclude the issuance of further debts, or preclude new debts unless they are junior to his own debts.

The borrower can forcibly obtain revenues, as by taxing. This applies to governments. An effective taxing power supports the government's ability to borrow.

Lenders audit the borrowers periodically to make sure that their ability and intent to repay have not been impaired.

How did Madoff gain the confidence of his investors? Which of the above methods did he fake? What kinds of information did investors rely on? What kinds of information should they not have relied on? What kinds of information did he fail to provide? What were the signals that he was being dishonest?

We will find out more and more as time passes. For one thing, Madoff used some intermediary financial firms. They attracted funds from investors, and then they invested with Madoff. This is legal, but, in my view, it is a questionable way for anyone to invest. The reason is that it involves two layers of fees and two layers of agency. Each new fee is hard enough to overcome as compared with buying an index. But also each new agent presents a problem of controlling the behavior of that agent. The bank agent that invested with Madoff had a lower incentive to provide an appropriate level of care than the original investor, and Madoff had an even lower level.

Madoff chose an obscure auditor that he may have controlled. At a minimum, he controlled the paper flow to that auditor. There is no choice in investing but to evaluate the auditor, little as we are able to do so. The intermediaries who invested with Madoff were not properly suspicious.

Madoff used relationship investing, including country club, religious, and such ties. Word of mouth is often an excellent supplement to other means of assessment. It should not be the sole means.

Madoff's primary method of gaining confidence was that the returns on investing with him were thought to be above-average and very steady, given the risk. They were manipulated to look that way. He offered what seemed to be a free lunch. In this case, what is too good to be true is not true. Mortgage loans offered at no or low interest are also too good to be true. Free Medicare benefits for everyone at a cost that is less than the amounts paid in payroll tax are too good to be true. 12% stock returns indefinitely are too good to be true when an economy is growing at 6%. The only remedy for these hopes and promises is to find out what kinds of returns have actually been delivered in the past and understanding how they have been delivered. High past stock performance arises when the price/earnings ratio is low at the start of the period and high at the end of the period. Medicare works as long as the pool of people paying in exceeds those drawing out, as in any Ponzi scheme. Low interest loans work until the interest resets higher or the property stops rising in price.

Madoff traded on his reputation earlier in life at NASDAQ. He betrayed his trust. The man is a scoundrel. There is little or no protection against such a person except the kinds of checking up that are mentioned above.

If you want to know how to invest, I suggest, as a beginning, reading The Battle for Investment Survival. In this book, Gerald Loeb recommends handling your own investments. He suggests dealing only in New York Stock Exchange listed securities and then only in an opportunistic way. That is, there will be many instances when one should be in cash or in some other asset class than stocks altogether. Leave exotic securities and methods to others. There is plenty of risk even in the best of liquid and listed securities.

There is a very great deal wrong with the way in which government has induced Americans, through laws and taxes, to invest through agents and pension plans whom they cannot control. The system discourages people from learning how to handle their own investments, and that is one level of protection against turning over large amounts of money to others, in the course of which one occasionally encounters the Madoffs of this world.

Our system of government automatically discourages us from handling our own governance. Despite the charades of voting and parties, our system precludes our handling our own governance. We are stuck with a great big Bernard Madoff called the U.S. government. He calls himself Uncle Sam and tries to establish a friendly relationship with us. Confidence in him is unwarranted. Beware.

LIVING TO TELL ABOUT MADOFF

“Madoff was the fraud that happened in full view, with lots of complicit partners.”

However slick the whole operation may have been, the signs that all was not quite right with Bernard Madoff's hedge fund were there from the start and they were not hidden. Anyone who conducted a modest amount of due diligence, as did hedge fund consultant James Hedges (not a misprint), would have quickly run across too many red flags to ignore. However, many simply did no diligence at all. Even doing something as simple as going to the SEC's website and entering Madoff's name would have revealed a citation for trading violations. Others who were supposed to perform proper inquiries had conflicts of interest that had the effect of paying them instead to look the other way.

In the end what perhaps most surprises us about the Madoff fraud is similar to what ends up puzzling us about stock frauds like Enron: With lots of legit options out there, why do so many people voluntarily flock to frauds? James Hedges was an experienced consultant when he investigated Madoff's fund, and some of the warning signs might not have been obvious to those less knowledgeable. But Madoff's refusal to supply an understandable explanation for how he made money did not even have to be taken as a warning sign. It could simply have been used as a filtering device, as in "I don't get it" means "Next!" (Incidentally, this would have eleminated a lot of the derivatives whiz kid flameouts from consideration.)

Dick Allen, a bad-boy baseball star in the 1960s/‘70s, said of artificial turf: "If horses can't eat it, I don't want to play on it." Treat artificial investment strategy explanations the same way. They may taste great, but are definitely less filling.

James Hedges, president and founder of LJH Global Investments in Naples, Florida, has invested billions in hedge funds and private equity since 1990 through relationships with numerous hedge funds.

His clientele have been said to include the Cargill family, of the privately held agriculture giant Cargill, Inc. He has also helped out the University of Pennsylvania endowment and the Rockefeller family, if legend has it correctly. And in 1997, he took a meeting with Bernard Madoff in New York to consider placing money with the man now accused of perpetrating a $50 billion global Ponzi scheme.

Barron's chatted recently with Hedges about why he was able to dodge a bullet when he walked out of Madoff's offices eleven years ago without a deal.

Barron’s: You once took a pass on investing in Bernie Madoff's fund. What troubled you?

Jim Hedges: I went in 1997 to meet Madoff, and spent two hours with him in his offices. His manner with me was wildly outside the traditional rapport I have had with managers and the kinds of access I have had to managers. I was told it was unusual for him to meet with anyone for that length of time, and that he was perturbed with the process. His whole tone during the meeting was curt, truncated, and he volunteered nothing. It was an extraction process to get him to answer anything. He was distracted the whole time, looking at people out on the trading floor through the glass wall of his office. Mind you, I was coming in to potentially invest billions of dollars for prominent families and institutions, representing extraordinarily well-known clientele. I could not be more the type of person for whom you would open up the kimono. And what it told me was that it was a fraud, full-stop. It was wildly impressionable on me. I have said over the years to many people: Do not touch Madoff with a barge pole.

What did you not like in that initial interview?

We have a due-diligence questionnaire that we use as a template for any investment. It is substantial, about 40 pages of factors we have to get comfortable with. It covers management's trading strategy, the back office, the pricing mechanism for the portfolio, how the manager is compensated, the checks and balances, and governance issues, and a whole host of other factors. We could barely get past page one with Madoff before alarm bells were going off. On the strategy itself, when I asked him to explain his investing strategy, it did not line up. His strategy was like [defunct hedge fund] Long Term Capital Management, where you are saying you are going to sweep up pennies and nickels around the globe via arbitrage opportunities. His representation that he was going to get free money gains from the marketplace, without a principal risk, did not make sense. One of the most important things in any fund investment is having realistic expectations. The client and manager buy into the same expectations. I looked at the return pattern that was offered, and my immediate reaction was it was too good to be true because of its predictable consistency. I saw no correlation between the strategy and how he delivered returns. I felt that the returns looked like what I and others have coined as "manufactured." In good times and bad times to have this consistent, narrow band of returns is not reality.

What else bothered you?

I literally remember waving my arms in the meeting and saying -- I am going to guess -- there were, like, 50 to 75 guys trading [stuff] behind his glass wall, out on the trading floor.

So what do these guys do? I asked. Because when you are investing with anyone, you want to meet the chef, and the sous chef, see who is preparing the dish. That request was turned down.

We do not ever allow investors to meet our team, is what Madoff said. I said, Let's go into pricing. Who holds the securities?

He said, We hold the securities. There was no global custodian, no prime broker. That never happens in a real business.

I said that what we do is look at three to five years of audited financials on funds.

He said, We are not going to provide audits. I was there representing a billionaire family, and to be told I could not gain access to an absolutely correct and appropriate thing to ask for, was amazing to me.

And then we get to an issue that is an enormous red flag to me. It was rumored to me at the time that there was $15 billion in assets under management at Madoff's operation. The assets have always been a heavily veiled secret. When I asked about assets and was patently shut down, it was moving beyond the realm of red flags into, This guy has got something to hide.

How is it that reputable hedge fund consultants such, as Tremont Capital, could have backed investments in Madoff's fund with all these red flags? What could Tremont and others have possibly been thinking?

I was far from the only person to draw the conclusions that I drew about Madoff. Madoff was the fraud that happened in full view, with lots of complicit partners. This kind of thing requires complicit behavior. I believe the due diligence conducted by investors who were there was faulty, or possibly they were lied to, or it was not even done at all, perhaps put aside in deference to a relationship with a con man. Fairfield Greenwich allegedly derived some $300 million per year from their Madoff product -- that is the rumor. When someone is paying you or me or anybody that much per year to go to polo matches with high-net-worth investors and tell them about their portfolio, or on their boat in the south of France, it is hard to imagine [that] one's vision does not get skewed. Tremont had $150 million of their value attributable to their Madoff feeder fund. You want people to believe that all that is squeaky clean because you are getting a $150 million payoff.

Is that common, that kind of conflict of interest, in this case?

A lot of this money in Madoff's operation came from European private banks with disintermediated private clients. If you go to one of these big private banks and look at their list of top managers, Madoff was always on the top of the list. You go around, as I have done for years, in London, Geneva, Monaco, it is always the same list of where they are putting their money. There is a "group-think" thing. And while the private bankers obtain fees for taking custody of the assets from investors and providing oversight and advice, the private banks and most of the conduits and feeder funds also were receiving what I call retrosessions -- fee rebates, soft dollars, however you want to term it. Some money was coming back from Madoff himself, so that the banks and conduits are getting paid both ways.

Is there further fallout for the hedge-fund business?

The shake-out from this is so far-reaching, it is the most fascinating story in my entire 15-year history of investing billions in hedge funds. It will impact hedge funds and fund of funds, because people are going to have to liquidate other positions. The real estate market, the art market, other asset classes, people will be seeking liquidity. The charitable foundations that will not be able to make gifts. The way in which hedge funds are marketed and managers' diligence is going to have to change.

So what is to be done?

If investors get more strident and responsible about due diligence and who they do business with, and hedge funds [are] more properly governed, this could be a silver lining in the next couple years. Hedge funds are a great business that has really, really gone wrong. It used to be all about innovation and performance. It was not about gaining access to institutional clients and having too much money to put to work.

As for regulation, the SEC had cited Madoff in '94 for some trading violations. You can go to the SEC's Web site [and] type in an advisor's name, and they pop up, and you can see if there is [anything] on them. Thousands of people never took the opportunity to do that with Madoff. While the SEC is taking culpability, at the end of the day, this is a situation where, it is not about regulation. I am not against further regulation in the least bit, but prudent regulation and procedures that are called for here to prevent this from occurring again -- not just more regulation for regulatory sake.

Questioning Bernie Madoff’s Too-Good-To-Be-True Track Record – In 2001

Barron's indulges in a little justified chest beating here. A staff writer looked into Bernard Madoff's claimed investment performance in 2001. The writer chose to highlight the skeptics she found rather than the Madoff true believers. She found no one who could explain how Madoff did what he did. That was enough for one advisor who took over a pool of assets that included an investment in a Madoff fund to order the investment liquidated. That should be enough for anyone.

Seven years ago, well before Bernie Madoff had been accused of fleecing investors of $50 billion in a massive Ponzi scheme, Barron's questioned his remarkable investment performance. One of our staff writers, Erin E. Arvedlund, talked with experts who were highly skeptical about Madoff's claimed results. One financial adviser that she quoted had pulled his clients' funds out of Madoff's shop for exactly that reason. Here is the story, excerpted in almost its entirety. (Erin was recently interviewed on National Public Radio about her story. Here is a link to the interview.)

---

Two years ago, at a hedge-fund conference in New York, attendees were asked to name some of their favorite and most-respected hedge-fund managers. Neither George Soros nor Julian Robertson merited a single mention. But one manager received lavish praise: Bernard Madoff. Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market-makers in Nasdaq stocks. Madoff Securities is also the 3rd-largest firm matching buyers and sellers of New York Stock Exchange-listed securities.

But what few on the Street know is that Bernie Madoff also manages more than $6 billion for wealthy individuals. That is enough to rank Madoff's operation among the world's 5 largest hedge funds. What is more, these private accounts have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.

When Barron's asked Madoff how he accomplishes this, he says, "It is a proprietary strategy. I can't go into it in great detail." Nor were the firms that market Madoff's funds forthcoming. "It is a private fund. And so our inclination has been not to discuss its returns," says Jeffrey Tucker, partner and co-founder of Fairfield Greenwich, a New York City-based hedge-fund marketer. "Why Barron's would have any interest in this fund, I don't know." One of Fairfield Greenwich's most sought-after funds is Fairfield Sentry Limited. Managed by Bernie Madoff, Fairfield Sentry has assets of $3.3 billion.

One of Madoff's hedge-fund-offering memorandums describes his strategy this way: "Typically, a position will consist of the ownership of 30-35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio's downside."

Among options traders, that is known as the "split-strike conversion" strategy. In layman's terms, it means Madoff invests primarily in the largest stocks in the S&P 100 index -- names like General Electric, Intel and Coca-Cola . At the same time, he buys and sells options against those stocks. For example, Madoff might purchase shares of GE and sell a call option on a comparable number of shares -- that is, an option to buy the shares at a fixed price at a future date. At the same time, he would buy a put option on the stock, which gives him the right to sell shares at a fixed price at a future date. The strategy, in effect, creates a boundary on a stock, limiting its upside, while at the same time protecting against a sharp decline in the share price. When done correctly, this so-called market-neutral strategy produces positive returns no matter which way the market goes.

Using this split-strike conversion strategy, the Fairfield Sentry Limited fund has had only four down months since inception in 1989. In 1990, Fairfield Sentry was up 27%. In the ensuing decade, it returned no less than 11% in any year, and sometimes as much as 18%. Last year, Fairfield Sentry returned 11.55% and so far in 2001, the fund is up 3.52%.

Those returns have been so consistent that some on the Street have begun speculating that Madoff's market-making operation subsidizes and smooths his hedge-fund returns. Why would Madoff Securities do this? Because, in having access to such a huge capital base, it can make much larger bets -- with very little risk -- than it could otherwise. It works like this: Madoff Securities stands in the middle of a tremendous river of orders, which means that its traders have advance knowledge, if only by a few seconds, of what the big customers in the market are buying and selling. And by hopping on the bandwagon, the market-maker effectively locks in profits. As such, throwing a little cash back to the hedge funds would be no big deal. And the funds' consistent returns, in turn, attract more capital.

When Barron's ran that scenario by Madoff, he dismissed it as "ridiculous."

Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. Three option strategists for major investment banks told Barron's they could not understand how Madoff churns out such numbers using this strategy. Adds a former Madoff investor: "Anybody who is a seasoned hedge-fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve." Madoff dismisses such skepticism. "Whoever tried to reverse-engineer, he did not do a good job. If he did, these numbers would not be unusual."

Adding further mystery to Madoff's motives is the fact that he charges no fees for his money-management services. Indeed, while fund marketers like Fairfield Greenwich rake off a 1.5% from investors, none of that goes back to Madoff. Nor does he charge a fee on money he manages in private accounts. Why not? "We are perfectly happy to just earn commissions on the trades," he says.

Madoff’s investors raved about his performance – even though they did not understand how he did it.

Madoff's investors rave about his performance -- even though they do not understand how he does it. "Even knowledgeable people cannot really tell you what he is doing," one very satisfied investor told Barron's. "People who have all the trade confirms and statements still cannot define it very well. The only thing I know is that he is often in cash" when volatility levels get extreme. This investor declined to be quoted by name. Why? Because Madoff politely requests that his investors not reveal that he runs their money.

"What Madoff told us was, ‘If you invest with me, you must never tell anyone that you are invested with me. It is no one's business what goes on here,’" says an investment manager who took over a pool of assets that included an investment in a Madoff fund. "When he could not explain how they were up or down in a particular month," he added, "I pulled the money out."

Out With the Old

Wall Street’s top strategists see stocks starting to recover in 2009, even as the economy deteriorates further. A dozen forecasters weigh in with what to buy – and what to avoid.

The clear concensus is that the economy will be getting worse for a while but -- perhaps, maybe, with luck, if xyz does/does not happen -- the stock market is cheap enough that most of the downside risk has been eliminated. This is not saying much, of course; and we are partial to the analyses we have seen which indicate that the market is trading at roughly fair value with the DJIA at 8000 and change.

So buying an index fund means you are getting a dollar of value for your dollar of invested funds, for the first time in a long time. Are there some market sectors where you can do better, effectively getting assets valued at more than their price? Here there is not much agreement, except that 10 of 12 strategists interviewed by Barron's favor the ever-popular health care sector. We usually favor being opportunistic in one's investments, and this most definitely looks like a stock-picker's market.

Because 2008 already suffers a surfeit of gloom, let us begin with a little good news: Wall Street's top strategists believe -- or hope -- that the U.S. stock market has already absorbed the worst of the selling pressure this year, and will start to recover in 2009. The not-so-great news: Any progress might be limited.

That is not to say there will not be violent rallies and sharp pullbacks along the way. An urgent scramble to dump risky assets and hoard capital this year triggered a crisis of credit -- and confidence -- that wiped out more than half of the stock market's value. And while stocks quickly rebounded 18% from their late-November low, the dozen strategists and chief investment officers surveyed by Barron's expect the Standard & Poor's 500 index to finish 2009 near an average of 1045, or 18% above today's level of 888. [See chart for where major market indexes currently stand.]

Such a forecast may not seem very modest at first -- until you consider strategists' vocationally bullish bent, how this volatile market can easily cover 18% in mere days, and all those statistics promising massive gains a year after stocks first slip into -- and presumably bounce out of -- a bear market. In fact, a majority of the surveyed strategists have pinned their 2009 year-end targets within a narrow 50 points of the 1,000 mark as though there is safety in numbers.

The source of their circumspection: the uncertain economy. Nearly everyone expects the U.S. economy to worsen as companies cut costs and lay off workers (on top of the 1.25 million jobs already eliminated from September to November), and as economists pencil in GDP declines of 4% or more for the 4th quarter of 2008 and early 2009. And while the consensus hopes for a second-half rehabilitation, no one knows when a lasting recovery will take hold. Indeed, 10 of the 12 firms surveyed see the U.S. economy contracting in 2009.

So why should stocks rise in the face of such ambiguity? For a start, the strategists hope that a stock market that has already fallen 52% from its 2007 peak to its November 20 low has discounted much of the deterioration still to come. With more than 37% of mutual-fund assets recently parked in money-market funds, the highest level since 1991, there is ample cash for bargain hunting should stocks dip below a certain threshold. Hopes run high that cheaper energy costs will support consumer spending, and -- most important -- that the deep freeze in the credit markets triggered by Lehman Brothers' collapse will continue to thaw. And everyone is counting on the government's aggressive policies to help stop the rot.

"The size of global policy response to stabilize both the financial system and the growth outlook is virtually unprecedented," says Morgan Stanley chief global equity strategist Abhijit Chakrabortti. "It does not appear likely to us that equity markets will fall substantially from here, given growth expectations have been substantially lowered, growth data are depressed and there is a high level of skepticism surrounding the ability of policy-makers to salvage the financial system and stabilize growth."

A year earlier, forecasters made the mistake of placing too much faith in the Fed -- back then, they believed the Federal Reserve's interest rate cuts and thriving foreign economies could help the U.S. stave off a recession. This time around, their trust may be more justified: At least the government is no longer in denial about the economic threat, and fighting deflation has become the urgent priority for governments around the world. Just last week, the Fed cut benchmark rates below a historic 0.25% and promised a vast array of lending programs to consumers and businesses.

At the same time, investor expectations have been quashed -- the bar is set low when today's yardstick is the Great Depression. Witness the lunge for safety and near-zero yields on short-term Treasuries. "People are practically paying the government to hold their money -- if that is not a sign of negative sentiment, I don't know what is," says Jason Trennert of Strategas Research Partners.

No one thinks wild swings will subside quickly from record 5%-a-day moves in October, but the downward plunges have at least been replaced by volatility of the sideways variety. "The market can rally fiercely and then pull back some," says Citigroup's chief investment strategist Tobias Levkovich. Over the 8 years after the 1932 bottom, there were at least 5 rallies that averaged 93%. The 1974 bear-market bottom spawned no fewer than 6 rallies over the next eight years averaging 32.5%. The surges, however, were followed by retreats, and Levkovich sees the choppy S&P 500 ending 2009 at 1,000.

If these strategists are right, the 39% gain from the November 20 low of 752 to 1045 might mark the tentative start of a new bull market -- or a big bounce within an extended bear market. Even those who expect the S&P 500 to hold its November 20 low see that threshold being tested in 2009 -- not immediately, since fresh allocations toward decimated stocks will provide a momentary lift. But buyers' resolve will be tested as early as February, when companies reporting messy 4th-quarter earnings offer a peek at the damage they have sustained.

Also, "I think a lot of bad decisions might have been made in the record volatility of this year's second half, and odds are there could be another surprise," warns Thomas Lee of JPMorgan. Potential threats that might rattle the market include a collapse of, say, a big U.S. industrial company or a foreign bellwether, or debt defaults by a sovereign power. Lee sees a range-bound first half, before a possible Q2 test spawns a constructive second half. All through 2009, Wall Street expects the Fed to keep borrowing costs at extremely hospitable levels to goose spending, and at least 9 strategists (or their economists) see benchmark rates kept below 1% even a year from today.

The flight to quality that drove 10-year Treasuries' yield down toward 2% last week also smacks of "a crowded trade and feels a little overdone," says Alison Deans, Neuberger Berman's chief investment officer. The firm's portfolio managers increasingly are scouring investment-grade corporate debt -- sporting attractive yields above 7% -- to park their money while browsing for stocks. In fact, 10 of the 12 strategists expect Treasuries to back off next year and for the 10-year yield to reverse its slide. The holdouts are JPMorgan, whose bond strategists see the benchmark yield finishing 2009 at 1.65%, and Merrill Lynch. (For Barron's bond-market outlook, see Current Yield. [See below.])

Anyone looking for change in 2009 will not be disappointed. As America weans itself off debt, and as the government begins to own banks, insurers or even automakers, a "tectonic shift occurs with the transfer of leverage from the private to the public sector," says Christopher Hyzy, chief investment officer of U.S. Trust, Bank of America's private wealth-management unit. The world's gross imbalances will begin to moderate. For example, developing Asia will see savings decline and spending rise, while the West, anxious to mend its balance sheets, will save more and spend less.

The clearest consensus about this period of rebalance and repair is for stocks to suffer limited downside risk, but also capped upside gains. But when pressed to pick which one of these two notions they feel more confident about, the strategists become quite evenly divided.

Bulls who think this tightly wound market is more likely to surprise to the upside point out how cheap stocks have become. "Bottom-up" predictions by Street analysts for the S&P 500 to earn $78 a share next year seem naïve, and surely will be slashed toward less-deluded "top-down" estimates from strategists who have factored in the weakening economy and who peg profits at $60.20.

David Kostin, Goldman Sachs's chief investment strategist, expects operating earnings to slip 33% this year to $55 a share, then fall another 5% next year to $53 before rebounding in 2010 to $69. While he steers clients toward more defensive companies with strong balance sheets and reliable dividend growth, he says that an overall market trading at 1.7 times book value -- half the 10-year average of 3.4 times -- is a sign "the equity market is undervalued from a long-term perspective."

Studying how far multiples shrank during previous swoons, Kostin pegs the trough for the S&P 500 at 850 if this proves to be an average bear market. But if this bear market plays out to a worst-case scenario, the bottom could be a lot lower, at about 630.

Valuation multiples expanded relentlessly in the 1980s and 1990s as long-term interest rates fell. Stocks won't enjoy the same lift today, with the 10-year yield already near 2%. Still, price-to-earnings multiples "are well below where they should be, given where interest rates are and where inflation is," argues Larry Adam of Deutsche Bank Private Wealth Management. He thinks multiples can expand as investors' appetite for risk returns.

"The S&P 500 also is at its most broadly diversified in at least a decade," Adam adds. Technology hogged 30% of the benchmark's weight in 1999, while financials took up more than 22% in 2006, but today the most prominent segments -- technology, consumer staples -- represent no more than 15% of the increasingly balanced market.

James Paulsen of Wells Capital Management says the U.S. was dealt a below-the-belt blow from which it can bounce back. "The one policy that had been tremendously effective was the well-orchestrated fear-mongering campaign" waged by the Treasury and the Fed to persuade Congress to pass a $700 billion bailout bill, Paulsen says.

The bad news: the resulting crisis of confidence frightened perfectly healthy corporations and consumers into suspending economic activity. "But the good news also is that it is a crisis of confidence," Paulsen says. "Just as we are surprised by the crisis's depth and severity going in, we might be surprised by how sharp the rebound can be going out."

Concerns about the collapse of consumer spending -- the engine that drives the U.S. economy -- also may have been exaggerated. "Credit won't grow at the rate we are accustomed to, but there is still pent-up demand from deferred purchases," says Jerry Webman, Oppenheimer Funds' senior investment officer. And let us not forget the boost that comes from $40 oil.

So what is holding stocks back? "If you have to point to one constant in the market, it is uncertainty," says Hyzy. More cautious strategists think the S&P 500 will struggle to sustain rallies above 1050, since investors will be asked to pay more than 15 times for per-share earnings of $70 or more.

Many strategists, of course, hope housing demand will recover as mortgage rates fall and as the new administration pushes consumer-friendlier reform. Unemployment might not peak until late-2009 near 9%, but it is a lagging indicator, since employers typically hold off new hires until they are convinced things are looking up. Still, weaker operating leverage, compressed profit margins, a stronger dollar and anemic foreign growth could all cap rallies.

Among the more prescient calls from last year's forecast was Merrill Lynch's prediction of "the first consumer-led recession since 1991," even if the firm, too, underestimated the severity of this year's selloff. While others were anticipating a profit rebound, Merrill also was among the first to forecast weaker profits in 2009 -- a view that has since become consensus.

Today, the firm still hews to its defensive crouch, although chief investment strategist Richard Bernstein reckons "2009 is likely to be better than 2008 for investors." Among other things, he preaches patience in the rush to pick a market bottom, "since the opportunity cost is low and there is a stiff penalty for being early and wrong." Merrill economist David Rosenberg thinks fiscal stimulus can help "cushion the blow but will not reverse the business cycle." Spirited consumption by baby boomers kept recent recessions short and mild. But now, "the average boomer is in his 50s and after two decades of spending, the boomer is done."

With this decade's booms -- in commodities, real estate, hedge funds and private equity -- all swelled by cheap money, Bernstein says the violent market shakeup and bursting of the credit bubble will pave the way for new market leaders. Defensive segments like consumer staples and health care may prove to be more than a temporary shelter, and could outperform even over the longer run.

Asked what it will take before he turns more bullish, Rosenberg flags three markers that could signal a sustainable economic expansion: the rise of the U.S. personal savings rate to 8% from 2%; a decline in the glut of unsold new homes, currently at 11 months' supply, to about eight months' worth; and for the percentage of household after-tax income spent servicing debt to fall from more than 13% to about 10.5%.

Where lurk the potential shocks? For many strategists, the happiest surprise is if the financial system gets fixed swiftly. That could drive the S&P 500 to 1190, and Chakrabortti pegs the chances of that at 20%.

By early next year, the losses suffered by banks and brokerages also will pass the $1 trillion mark, and "odds are good that markdowns and provisioning have already peaked," says Chakrabortti, who warned more than a year ago that downturns led by housing -- the world's slowest-moving assets -- tend to be prolonged. Improving value for deeply discounted loans might even trigger "write-backs," where financial firms that have not dumped their debt get to bump up the value of their loan portfolios.

On the other hand, policy failure and dislocated financial markets could send the S&P 500 to 400, the odds of which Chakrabortti pegs at 25%. "Another potential downside surprise is if Asian or emerging-market consumption falls sharply -- I do not think that has been discounted by the market."

“The trade of 2009 will be to figure out when to stop playing deflation and begin playing inflation again.”

Meanwhile, inflation -- so feared just a few months ago -- goes virtually unremarked these days, even though the government bluntly promises it will print as much money as necessary to keep the financial systems functioning. "The trade of 2009 will be to figure out when to stop playing deflation and begin playing inflation again," Trennert says.

Against this uncertainty, model portfolios must walk a delicate balance between guarded and bold: The three sectors favored by BlackRock's global chief investment officer Robert Doll are health care, with its strong cash flow and its defensive stance; technology, which straddles the divide between stability and cyclicality; and energy, which is the most economically sensitive.

Forcing borrowing rates down to zero will need time to work. In this climate, Hyzy prefers "the top of the capital structure" -- essentially more secure senior debt -- and keeping an eye on small- to mid-cap stocks that could outperform if the Obama administration manages to stimulate job creation. He also emphasizes infrastructure and defense stocks. "There is a propensity for violence during tough times, and conflicts can arise as the global economic downturn picks up steam," he says. "We must be prepared for that."

While the market has flocked toward quality -- strong balance sheet, robust cash flow, predictable profits -- investors should keep an eye out for improving credit spreads and a return of risk appetite. "At some point, the argument for quality could become long in the tooth, and lower quality will do just fine -- thank you very much," Doll says. When that happens, investors might shift some money from big pharmaceuticals toward HMOs within health care, from software toward select chip makers, and from big integrated oil companies toward explorers and refiners. Ditto a shift from the currently popular domestic focus back toward multinationals with international clout.

No surprise: health care is the new year's most crowded trade, with the sector beloved by 10 of 12 strategists. [S&P sector performance here.]

Curiously, technology was favored by 5 out of the 6 buy-side CIOs, but not one sell-side strategist. Deutsche's Adam, for one, likes tech companies' cash stash and self-sufficiency from the debt market. Inventory is disciplined after the bloated bubble years, and technology improves productivity of companies operating with leaner staff. Our next president, Barack Obama, is a tech-savvy broadband geek, and even his health care reform includes tech-reliant proposals like the modernizing of medical records.

The knock on the sector, however, is how companies might find it easier to slash capital spending than lay off workers. Credit-market indicators suggest that payrolls will shrink another 3% by the summer, but capital spending could be cut 15%, says Citi's Levkovich. "Companies that sell to consumers could suffer, but companies that sell to other companies will be worse off," he says. His picks include retailers, where "expectations are already extraordinarily poor."

A chasm also has opened up in financials, which is favored by 4 sell-side strategists. "America's private debt -- the aggregate value of household and corporate debt -- is trading at 70 cents on the dollar, and that is not the right price," says JPMorgan's Lee, who expects this fear-driven discount to narrow after the rush to delever. Tightening credit spreads and a steeper yield curve also should help financial firms.

Financial stocks need a lot more time to recover from the pricking of the credit bubble.

Oddly enough, not one of the surveyed buy-side managers is ready to warm up to financials. Like tech stocks earlier this decade and energy stocks in the early 1980s, financial stocks need a lot more time to recover from the pricking of the credit bubble. "More capacity needs to be taken out, which means more bad debt, write-offs and consolidation," Doll says. "Policy is an ameliorating factor and it is targeted at financials, the sickest part of the market. But if it works, it will benefit the whole economy." In other words: Why risk betting on financials?

Meanwhile, the sectors that led the most recent bull market have become its new pariahs: Energy is recommended by just two strategists, and materials by only one. "While demand for commodities will be hurt in a global recession, we have done virtually nothing to solve our oil dependence," says Doll, who sees energy stocks bouncing should the economy return to any semblance of normalcy. Crude oil has also fallen more than 70% to below $40 a barrel, and Doll sees the $40 level "as a flashpoint below which oil-producing countries will curtail supply." (OPEC, in fact, voted last week to reduce supply.)

In contrast, 4 strategists suggest avoiding energy, 4 are dissing materials and 5 suggest steering clear of industrials. Quite remarkably, 12 of these 13 negative calls against these commodity-driven sectors are from the sell-side. Materials and industrial companies, for instance, are famously capital-intensive. They suffer big depreciation expenses that erode earnings and pressure margins, and commodity prices are still falling. "The bar is set very high for companies that led the previous bull market," Lee says, "and it is rare for old leaders to reassert themselves."

For that matter, even the vanquished bull market itself will need a little help -- and a little hope -- to reassert itself in the year ahead.

INTEREST RATES MAY CLIMB, BUT NOT BY MUCH

Shunned credit-crisis doomsayers are mostly vindicated.

In the fall of 1982 Stan Weinstein, then the editor of a respected technical analysis newsletter called The Professional Tape Reader, presciently but abstactly predicted that by the time the bull market was over "even the bulls will be surprised." The basic message was correct, and even useful, but also extended skeins and skeins of rope with which the amateur investor could hang himself. Instead of just sitting still, many traded in and out of a secularly rising market and hurt their results.

Something of the reverse of that situation occurred with the bears this past year. Many had been predicting doom of some degree for years. Yet when it happened, before it was all over -- whether it now is already over or not -- even the bears were surprised. We suspect many jumped out of government bonds and back into the stock market too quickly, instead of reaping the full benefit of their foresight. In the face of the virulent credit deflation turned that emerged, interest rates fell more than anyone forecast. Now what? No one seems to think rates will rise much in 2009.

How bad a year was 2008 for interest-rate forecasting? Even those who correctly foresaw the impact of the housing and credit crisis on the economy could not imagine the unprecedented plunges in interest rates that it would produce.

For instance, Paul Kasriel, Northern Trust's chief domestic economist, was quoted a year ago in this space saying that "the housing recession will continue and the fallout from it will push the economy toward a recession, if it is not already in one now." Relatively extreme at the time, that turned out to be remarkably prescient.

But rates fell far more than Kasriel -- or just about anybody else -- could conceive at the time. Even Merrill Lynch's David Rosenberg, who has consistently warned of the economy's vulnerability to recession and whose predictions for significantly lower rates in 2008 came closest to the mark, nevertheless had forecast numbers that were nearly twice as high as the actual outcomes. Last week, the Federal Reserve slashed its target for overnight federal funds to a range of zero to 0.25%, down from 1%, which had been the previous record low for the key rate. Meanwhile, with short-term Treasury bills yielding essentially zero, intermediate and longer-term yields have been following lower. Thursday, the benchmark 10-year note came within a hair of 2%, lower than it has been in more than a half-century.

Virtually all economists sampled in our semiannual survey -- which is designed to take in the spectrum of opinions, not to be a comprehensive poll -- expect the Fed to maintain its current 0-0.25% range for fed funds (represented in the table here as the midpoint). Only a few look for the Fed to nudge the funds rate up, later in 2009.

Likewise, few seers think Treasury yields can stay at current low levels or even decline further. Yet Ed Hyman, head of the ISI Group, sees a severe global recession taking yields down from here. And Merrill's Rosenberg expects a recession more like the ones seen before World War II, which were longer and more severe than those of the post-War era.

Even those who foresaw the downturn in the economy and interest rates now look for the massive stimulus from the Fed and fiscal policy from the Obama administration to arrest the contraction. In due course, as a result, bond yields should rise from their current depressed levels, but only modestly as inflation remains in check.

Money rates also continued to recede in response to the Federal Reserve's latest easing moves.

Kasriel notes that, even with the policy blunders of the early 1930s, the economy began to recover by 1933, and inflation turned higher a year later. Given the aggressive Fed easing and likely huge stimulus under Obama, the economy and inflation should turn higher by 2009 and 2010, respectively. Similarly, Michael T. Darda of MKM Partners thinks that expansionary efforts may overcome deflation by 2010; meanwhile, high-grade corporates and Treasury Inflation-Protected Securities would benefit.

Other forecasters agree that the fiscal and monetary boosts will begin to produce results in 2009, but worry about their aftermath. "While history says the odds of this policy approach working is quite high, one of the potential negative consequences could be a resurgence of inflation in the long-term," observes Joe Carson of AllianceBernstein. Indeed, John Ryding of RDQ Economics thinks the risk of the Fed's expansionary policies is a renewed fall in the dollar, while a massive increase in federal borrowing would cut foreigners' demand for U.S. bonds and could drive up yields.

There is little debate that the economy is in a steep decline caused by the debt deflation resulting from the credit crisis. The key point of disagreement is how effective government efforts to counter the crisis will be, and if they are, when we will feel their effect. It looks like another interesting year.

CASHING IN ON THE CASH BUBBLE

The flight to liquidity has resulted in extraordinarily low yields on T-Notes and T-Bonds, and zero or even slightly negative yields on T-Bills -- the equivalent of cash stuffed in the mattress for those with too much to use that tactic. Is that indicative of a cash bubble? That is stretching the idea to its limits. Fundamental to the operational concept of a bubble is that credit is flowing into the asset under examination, whereas the preference for cash is the flip side of credit coming out of other asset classes.

So perhaps the real question vis a vis cash today is whether safety is overvalued. This implies that riskier assets like stocks, non-government credit, etc. are undervalued. Options traders have some more exotic alternatives for playing a flight from safety.

Is cash a bubble? Are investors too risk-averse?

Options traders are now debating these controversial questions as they prepare for a 2009 that they hope will be more sanguine than 2008, which challenged long-held assumptions about options pricing and the fundamental nature of volatility.

Traders say the "cash is king" mentality is so pervasive in the financial community that it may be primed to join the list of bubbles that have burst over Wall Street, including stocks, oil, agricultural commodities and subprime mortgages. Of course, a bursting cash-bubble would help, not hurt, investors, as stock prices would advance.

A lot of traders are buying -- or debating doing so -- bullish calls on stocks and sectors. The more battered the security, the better. They see options as a cost-effective way to balance the risk that the market could worsen in 2009, rather than improve, while ensuring they do not miss any rallies.

Investors, especially many mutual-fund managers with investment charters, are taking a more muted approach. They are selling richly priced calls, and using the proceeds to lower the costs of buying stock. The trade permutations are almost endless.

"Cash is the elephant in the room," says a strategist at a top investment bank who spends his days dealing with portfolio managers. "Everyone has lots of it, and I don't know when they are going to start taking risk, but I want to be in right before it happens."

The recent clamor to buy 4-week Treasury bills with a 0% yield perfectly expresses the market's mania for absolute safety, while the Federal Reserve's decision to lower the federal-funds rate to a range between zero to a quarter of a point suggests Federal Reserve Chairman Ben Bernanke is waging war on cash to force money back into the financial system. "Bernanke is trying to break the bubble in cash," says Steve Sosnick, risk-manager for Interactive Brokers' Timber Hill market-making unit.

If the cash bubble bursts, the record amounts of cash held by investors and corporations would flow back into the financial markets, benefiting stock prices and other assets, including fixed income, emerging markets, commodities and currencies. Even moribund investment bankers might get some action if corporations resort to mergers and acquisitions to increase depressed earnings, or diversify product suites.

While everyone would love to see the cash bubble burst because it would lift equity prices, the cash-as-bubble makes many traders uneasy, because it underscores the woes of the financial system.

Nascent bulls, and bears, are afraid the global economy's recessionary tailspin could get worse, and that volatility could sharply increase again, in response to unexpected events. What happens if President-elect Obama does not live up to the market's expectations for inspired leadership? Another big Wall Street scandal or another toxic Fortune 100 balance sheet like AIG's would spook the market.

Yes, there is still good reason to be afraid of parting with cash. In a consumer-driven economy like America's, conditions could worsen if consumers do not soon start consuming again. Rising unemployment is also a major risk factor.

It is difficult to find another point in modern time when investor sentiment was more negative than today. Three-month realized volatility of the Standard & Poor's 500 Index was recently 71.86%, surpassing the high of 68% set during the Great Crash of 1929. The Chicago Board Options Exchange, the largest U.S. options exchange, is budgeting for a 15% decline in 2009 trading volume.

But traders know that hype -- and "cash as king" is a good candidate -- always ends in a major transfer of wealth on Wall Street.

"One way to play this is to buy 20-delta calls on riskier stocks or even 6-month or 1-year wide call spreads on those riskier names -- retailers, airlines, homebuilders," says Jack Gonzalez, who deals with many hedge funds as UBS's head of derivative flow sales.

Delta is the rate of change in an option's price in response to changes in the underlying stock. A 20-delta option is typically far out-of-the-money. A 100-delta option is essentially a stock proxy.

While not mathematically correct, many traders think 20-delta calls have a 20% chance of finishing in-the-money. So buying 20-delta calls on risky stocks offers a cost-effective way to wager on rebounds without risking tons of money.

Gonzalez likes buying Lennar (ticker: LEN) January 15 calls that expire in January 2010, and selling the 25 calls with same expiration date. He also likes call spreads in Centex's (CTX) January 17.50/30 call spread at $2.40, Dryships' (DRYS) 17.50/25 for $1.70, Las Vegas Sands' (LVS) 10/20 call spread for $1.70, and OfficeMax's (OMX) January 10/17.5. All options are January 2010 expirations.

"There are many trades out there that have 5:1 payouts because options volatilities are so high," Gonzalez says.

Investors willing to risk a bit more money than a 20-delta call can buy 10% to 20% out-of-the-money calls in favored sectors, or stocks.

A growing number of traders think the financial sector, battered as it is, will rebound in 2009. They are buying out-of-the-money March and June Select Sector Financial SPDR (XLF) calls in anticipation the sector will advance in 2009 after falling some 56% this year.

Many mutual-fund managers, whose investment charters permit the use of derivatives, are increasingly consulting options strategists about "buy-writing. "This strategy entails selling out-of-the-money calls and buying stock. Investors who use this strategy can use historically high options premiums to lower the cost of stock. The risk is that options volatility increases.

Sveinn Palsson, a Credit Suisse derivatives strategist, is advising clients to sell calls against Exxon Mobil (XOM), which he says is the "T-bill of equities."

"A cash bubble is defined as a condition in which investors shun everything but the safest assets," Palsson says. "This flight to quality mindset that pushed T-bill yields below zero has also translated into the equity world as a demand for stocks with proven cash flows."

Palsson notes that Exxon has the free cash flow of $37 billion, the highest in the S&P 500, and the largest cash reserves of all non-financial related stocks with $34 billion. Many investors have recently bought Exxon, and Palsson likes selling the January 85 call against the stock as it appears to be "overbought."

Jon Najarian, co-founder of OptionMonster.com, a trading advisory, said cash hordes are so high that they could stress the financial system when reinvested.

"It could be the biggest January effect ever," Najarian says.

And that would be a lovely way to start 2009.

HOW TO PLAY A “TAKE-NO-PRISONERS” MARKET

Given the abundance of low-hanging fruit, it is a mistake to stick with things that will soon go out of style, such as Treasuries.

Rob Arnott is a smart man with a lot of integrity. He has little tolerance for the self-deluded thinking that goes around the money management industry -- where all money managers are above average, even after management fees. Thus he is a major proponent of indexing, due to its low costs. Unlike most indexing advocates and practitioners, Arnott does not stop there and bow down at the temple of the McGraw-Hill stock picking committee, which creates the Standard & Poor's 500. He tries to discern the true constituents of performance. This has led him down the path of becoming one of the foremost experts in "fundamental indexing," where company weightings in indexes are based on criteria such as cash flow and book value rather than market capitalization, i.e., pure size.

In this interview with Barron's, Arnott recapitulates many themes seen in these pages before -- today is the dénouement of reckless credit creation, stocks are not necessarily cheap now, the dollar is in trouble long-term, and all that. Which is not to say he recommends sitting on your cash, which would be "investing with your eyes in the rearview mirror." In fact Arnott thinks that those willing to assume risk are being extraordinarily well compensated today: "This is not a time to be hunkering down in the safety and comfort of the Treasury curve." More colorfully: He sees "the richest environment of low-hanging fruit I have seen in my career." He just happens to think that this does not point to the usual conclusion that the best place to be is stocks. Read on.

Rob Arnott, founder and chairman of Asset Manager Research Affiliates in Newport Beach, California, is one of the big thinkers in finance today. A former editor of the prestigious Financial Analysts Journal, Arnott, 54, has developed expertise in asset allocation, indexing, and pension funds, among other topics. He is a fierce proponent of fundamental indexing -- in which metrics such as aggregate sales and cash flow are used to weight companies in an index, as opposed to market capitalization.

With the markets in tatters, Barron's turned last week to Arnott, who in a wide-ranging conversation had plenty to say about fundamental indexing and many other subjects. "This is not a time to shy away from taking risks," says Arnott, who maintains that the market's upheaval has created great investment opportunities, including value stocks and convertible bonds. "The markets are priced right now to reward risk-bearing more than any time in many, many years," he says. Hence, he sees Treasuries, which had a relatively strong 2008, as the worst place to put money next year.

While the fundamental index Arnott uses smartly outran the Standard & Poor's 500 from 2000 to 2006, it underperformed the S&P in 2007 by three percentage points and is behind in 2008, as value stocks got shellacked. Yet Arnott's faith in the approach remains unshaken. To find out why, please read on.

Barron’s: What are your thoughts on this year's dismal market?

Arnott: What we have seen is the consequence of reckless indebtedness. Subprime was the tip of the iceberg. I found it interesting that folks in government were dismissive of subprime as being not a terribly important issue as recently as late 2007 and even early this year. There has been this pattern of aggregate indebtedness at the corporate level, at the household level and at the government level. It is dismissive of the need to pay things back. As a result, when things started to go sour on some of this debt, beginning with subprime, the cascading effect was beyond what most people could have anticipated. I was a bear coming into this credit crunch, and I actually was labeled a perma-bear. And yet this contagion effect went a lot further than I would have predicted, and there are very few observers who expected anything this severe. But the seeds of it were sown quite aggressively over the last decade.

How did all of that fall into place?

The indebtedness of the United States rose from five times GDP to eight times GDP in 10 years. That is reckless, but that is what has been going on. That sowed the seeds for what we have seen. The deleveraging that has taken place has cascading effects that can come from a lot of different directions and can afflict a lot of different markets.

What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally in November, we saw the beginnings of a rationalization where some markets did begin to recover -- but some markets had been hit beyond any rational valuation of the risks associated with those assets.

What should investors be doing differently in the wake of this huge market downturn?

As shown by the collapse of Bernard Madoff's firm, investors should act with due diligence -- that is, they should be more alert to the risks. We have had a cult of equities develop over the last 20 years in which equities were seen more as the low-risk asset, even the risk-fee asset for those who had a long-term orientation, and that is foolishness. If you are bearing risk, you should get paid for it. If you are picking up nickels in front of a steamroller, trying to identify opportunities to add 1/10 of a percent to your return by taking risks that could cost a 100 times that, that does not make sense. People need to be more disciplined about that. That includes individuals, corporations, and banks.

This temptation to buy what has done well is the single greatest pitfall in investing.

In light of what has happened this year, what is the best way to approach asset allocation?

Almost everybody, retail investors and institutional investors alike, invests with their eyes in the rearview mirror, favoring what has worked best in the past. But there is a very powerful pattern of mean-reversion in the markets. What has done spectacularly well often takes a rest or it takes a bear market to get back to normal. So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors. That goes for your readers, and it goes nearly as much for highly sophisticated institutional investors. This temptation to buy what has done well is the single greatest pitfall in investing, and it is the single reason that a disciplined approach to asset allocation can actually work very, very well.

What is an example of a promising area hit hard?

The average convertible-arbitrage hedge fund was down about 50% year-to-date at the end of last week. But that result for a long-short absolute-return, fully hedged strategy makes no sense. The temptation is to get out, which is what a lot of investors are doing. The other way to look at it is that the forced liquidations of these hedge-fund positions create new opportunities, namely convertible debt priced at extraordinarily attractive yields. The same thing holds true for emerging market stocks and bonds, along with TIPS [Treasury inflation-protected securities].

A year ago, folks were probably getting tired of hearing me say there is no low-hanging fruit and that there are no attractively priced markets, both relative to other markets and relative to their own history. I also was saying not to expect double-digit returns and to take risk off the table.

“This is the richest environment of low-hanging fruit I have seen in my career.”

What is your view now?

It is pretty much the opposite; this is the richest environment of low-hanging fruit I have seen in my career. And you would have to go back to 1973, 1974 or even, in some markets, to the Great Depression to find markets priced as attractively as now. This is not a time to be hunkering down in the safety and comfort of the Treasury curve. There are tremendous opportunities right now. It is so tempting in a bear market to focus on the glass being half-empty and on how much has been lost. But the glass being half full side is largely ignored.

What kind of an asset-allocation mix makes sense to you?

First of all, most investors think that putting some money in growth stocks, some money in value stocks and some money in international stocks is a well-diversified portfolio. It is not. Diversification means taking on risk in markets that are uncorrelated and that can go up when other markets go down. So a well-diversified portfolio should look at multiple sources of risk, not just in stocks.

I do not see how the dollar can do well on a long-term basis when we have indebtedness that is eight times our national income.

Where do you see opportunities?

A year from now, investors in convertible bonds are likely to be very pleased with what they [see] in terms of prices and yields. The same holds for emerging-market debt denominated in the local currency, which I prefer to dollar-denominated debt. You get a premium yield for emerging-market debt and an additional premium for investing in the local currency. Tacitly, that is a dollar bet, but I do not see how the dollar can do well on a long-term basis when we have indebtedness that is eight times our national income. Imagine an individual going to a bank and saying, "I owe eight times my income and I would like to borrow more." The reaction would be immediate and drastic: "Give us your credit cards; we will slice them up." But as a nation we still have our credit cards, and we are still using them aggressively.

What other kinds of investments look good to you in terms of asset allocation?

I also like TIPS. How can we get out of this current mess without renewed inflation? A lot of folks are deeply concerned about the risk of deflation. The temptation is to look at history, especially the Great Depression, which was a deflationary depression and which started with very, very low national indebtedness. If you have very little debt and you have a depression, it is likely to be deflationary. If you have very high debt and you have a depression, it is likely to be massively inflationary. The contrast with Germany in the 1920s is noteworthy. They had massive indebtedness and hyperinflation. I am not suggesting a risk of hyperinflation. But I am suggesting that people are too glib about tossing aside the risk of inflation, which was front and center less than six months ago for most investors.

What is your sense of opportunities in value stocks versus growth stocks?

The value side of the market is priced for a depression, the growth side for recession.

When you look at price-to-book values, the spread between growth stocks and value stocks was at its narrowest ever, just two years ago. Now, it is the widest spread ever with the sole exception of the bubble year, in 2000, and we saw what happened after that: seven years in which value drastically and reliably outperformed growth. We could see something similar [now], whereby value sharply outperforms growth. The value side of the market, like much of the bond market, is priced for a depression. The growth side of the market is priced for recession.

You are a big believer in fundamental indexing, in which metrics such as dividends and book values are used to determine a stock's weighting. That is in contrast to weighting an index by market capitalization, such as the S&P 500. The FTSE RAFI 1000 Index, which takes a fundamental approach, trailed the S&P 500 this year by about three percentage points, as of December 16 -- although it has outperformed over longer time horizons. What caused that underperformance this year?

It is due entirely to value [stocks] getting shellacked. The capitalization-weighted indexes put more money into companies if they are trading at high-valuation multiples. So, cap-weighting systematically puts most of your money in growth companies, while a fundamental index has a value tilt relative to the market. Value was savaged in 2007 and 2008. So the fundamental index underperformed surprisingly modestly.

In contrast, the FTSE RAFI All World 3000 was down 39.46% year-to-date as of December 16, more than 200 basis points ahead of the MSCI All Country World Index. And it outperformed last year as well. So [fundamental indexing] has won worldwide in extremely difficult markets. It has not won in the U.S. in 2007 and 2008, but the shortfalls are pretty mild -- considering how severe things have been on the value side of the market.

You have said that investors cannot bank on equities returning 10% every year, on average. What is a realistic target?

The yield for U.S. stocks is around 3.5%. Historically, earnings and dividends have grown about 4.5% per annum. So if you have 4.5% growth and a 3.5% yield, that is an 8% return. I am sure your readers would love to hear a forecast of double-digit returns, especially given the biggest bear market since the 1930s. However, our starting point was from valuation levels that were so very rich that we are now merely back to levels that could provide long-term returns of around 8% from current levels. There are segments of the bond market where we can almost assuredly do better.

Stocks are not attractively priced relative to their own bonds.

You do not sound like you are sold on stocks, Rob, even after this huge selloff.

The problem I have with stocks -- and it is a very simple problem -- is that while stocks are nicely priced, they are not attractively priced relative to their own bonds. The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.

Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return? The stocks will, if they show earnings and dividend growth faster than 6% -- but historically that is a stretch. So the bonds have been savaged worse than the stocks have, and actually represent the most interesting opportunity.

So you are talking about investment-grade bonds?

Yes, investment-grade bonds. But for bonds below investment grade, the spreads are quite extraordinary. By the end of November, spreads had widened out to nearly 20 percentage points above Treasuries and also above the corresponding stock yields. Suppose 40% of those bonds go bust next year. And suppose that you get 50 cents on the dollar back on the bonds that go bust. By that point, you have lost your spread of 20 percentage points.

2009 is an “ABT” year – Anything but Treasuries.

But such a scenario has to happen every year, until the high-yield bonds mature, in order to merely match Treasury returns. A 40% default rate every year for several years would be truly without precedent. So I view 2009 as an "ABT" year -- Anything but Treasuries. The less you hold in Treasuries, the better you are likely to do.

Has the market bottomed out?

There is a slightly better than 50-50 chance that we see another leg down in the stock market. That is because the deleveraging in the economy is only partly under way, and there is a lot more of it to come. The mass liquidation of hedge funds is not done. As for the economy, I am expecting 2009 to be a bit worse than people expect. I see the housing market turning in late 2010 or early 2011, definitely not next year. It would surprise me quite a bit, however, if the risky categories of bonds take another significant leg down.

It has been a tough time for indexing, given that so many index returns are negative this year. What kind of an impact will this down-market have on indexing?

People put money into index funds partly because indexes beat most active managers. Nothing is going to change that because, collectively, active managers hold essentially the same assets as the indexes. So collectively, their returns have to be the same, minus costs, which are larger. As a result, indexes will continue to win on a long-term basis. When they underperform, they tend to underperform by less than they win when they outperform. All of this means that demand for indexing is not going away, and it will continue to be a major source of growth among institutional and retail investors. We will see more index offerings so that people can choose different kinds of indexing, such as fundamental weighting.

What is ahead for hedge funds?

There are a lot of good hedge funds out there. But the situation regarding Bernard Madoff's firm illustrates that hedge funds have very little transparency and that their customers do not demand transparency.

I think the aftermath of this will be that some form of regulation in the hedge-fund world is coming. The more the industry embraces and tries to steer that dialogue, the less displeased they will be with the outcome. Still, a lot of investors have had multiple wake-up calls this year about the need to ask more questions and the need for basic due diligence. Too much of the hedge-fund community, however, is still a wealth-transfer vehicle from client to manager. We will continue to see substantial liquidations, which will continue to exacerbate the deleveraging problems we have right now.

There are 10,000 hedge funds out there, and maybe 500 of them are good. But 400 of those are closed.

Could you elaborate on your point about hedge funds being a wealth-transfer vehicle?

If a hedge fund charges a 2% management fee plus 20% of the gains, that is the classic fee structure. If a hedge fund is extraordinarily good, it is worth the cost. But the fees do not make the manager good; it is the other way around -- it is the skill of the manager that justifies the fees. A lot folks go into these funds thinking, "Well, if these guys can charge 2% plus 20%, it must be good." And some of these funds are good. There are 10,000 hedge funds out there, and maybe 500 of them are good. But 400 of those funds are closed. So finding the 100 that are open and good in a universe of 10,000 managers is highly implausible.

Thanks, Rob.

SHORT TAKES

Shelby Davis: The Best Stock Investor You Have Never Heard Of

Shelby Cullom Davis achieved an extraordinary 23%+ annual average return on capital over a 45+ year investing career, using an approach which would ring familiar to anyone who has studied Warren Buffett's career. We do not know enough specifics to assert this outright, but it sounds like Davis had a record comparable to Buffett's. Davis's career started 10 years earlier than Buffett's, yet Davis is barely remembered today. Chris Mayer stumbled upon a book, The Davis Dynasty, which sounds like rewarding reading.

For the first time since 1940, the yield on the 3-month T-bill went negative this month. Investors eagerly bought up a negative 0.01% yield. That means that they would rather lock in a certain 90-day loss than risk anything in the stock market. ... I want to explore this idea of investors seemingly selling anything to raise cash or its near-equivalent, Treasury bills. ...

Essentially, people are looking to turn just about anything they can into cash. Once again, you have to go back to the 1930s to find anything comparable. I found some good nuggets in an old book about a great forgotten investor.

I was rummaging around some old books in my office the other day, cleaning some stuff out, and came across The Davis Dynasty by John Rothchild. I started to flip through it and remembered the tales of the world's great investors. Much of the information below about the Great Depression comes from Rothchild's book.

By 1931, the economy was shrinking like fresh spinach in a hot pot. Commodity prices fell to levels not seen since the 1870s. As today, companies cut back. Profits fell. Layoffs were common. Consumers cut back. Debts went into default. And the market tanked.

Art Loom was the creation of the Wasserman family. It sold rugs. The Wasserman family was one of the lucky ones to avoid the Crash of 1929. It kept its fortune in bonds. Joseph Wasserman once said, "The rug business is risky enough. I want to be conservative in savings." Fortunately, that capital would seed the start of one of history's great -- if largely forgotten -- investors. His name was Shelby Cullom Davis.

The numbers, according to Rothchild, are amazing. Shelby Davis started investing in 1947, and was 38-year-old former freelance writer. Luckily, he married well. His initial stake of $50,000 came from his wife Kathryn Wasserman, daughter of a carpet mogul. Davis did well by them. By the time of his death in 1994, he multiplied that stake 18,000-fold. He turned $50,000 into $900 million.

Davis made the Forbes 400 list in 1988. He was the only one other than Warren Buffett who made the list by picking stocks for a living. Shelby Davis followed the old way of getting rich investing in stocks. He kept a long-term perspective through bull and bear markets and followed the basic tenets we talk about all the time here. He stuck with what he knew -- in his case, mostly insurance stocks. He had a passion for investing and stuck with it even when times got tough.

I found his story inspirational. Stay with investing and do not give up on stocks -- especially now, when so many are so cheap.

In the next bull, 15 could be the new 20. Get used to it.

The next bull will not be nearly as robust as the last two, and valuations will prove it.

This article provides a probably unnecessarily complicated explanation about why stock multiples are not going back up to their old levels any time soon. It really comes down to Keynes's "animal spirits," which the article actually mentions.

Multiple expansion is not a reliable source of investment returns anyway. Yes it is great when the market discovers the virtues of the little gem you so sagely got in on ahead of the crowd and marks up its multiple, leaving you free to sell out and move on to your next killing. If you can play that game consistently over an extended period, more power to you. Most people cannot. The only reliable driver of a higher stock price is high sustainable earnings power. That is even more true of the market as a whole. It should over time go up as fast as earnings, and no faster. Add that growth in earnings to the dividend yield and you have a reliable basis for your investment return. End of story.

Much of the equity markets' rise in the 1982-2000 and 2003-2007 bull spans resulted from the fall of the Berlin Wall; the rise of global capitalism, in which the U.S. would play a preeminent part; and the attendant idea that the rest of the world would someday be able to buy cars, TVs, crude oil, you name it, in the same prodigious way Americans did. But the U.S.'s unusually strong economic growth in the past decade could turn out to have been temporarily juiced -- a nation on steroids, its performance artificially enhanced by unsustainably large doses of leverage, both by banks and consumers.

That level of leverage is gone and probably not coming back in the same fashion. "It was effectively the leveraged buyout of the U.S. household, fueled by delusions that a national house recession would not happen," says David Hendler, a savvy analyst at CreditSights. "Consumer spending will not come back. Not quickly, and not for many years," he predicts. With those dollars amounting to 2/3 of the U.S. economy, this retrenchment has crucial implications -- for sustainable corporate profit growth as well as returns on equity that should be expressed through the market's average price/earnings ratios in the next bull, whenever it arrives.

"Investors will have to get used to the idea that returns will be less but perhaps more stable," notes Henk Potts, an equity strategist with Barclays Wealth. To slower-growth woes, he says, add a stricter regulatory environment for corporations and financial markets: "It's the end of the light touch to regulation." That will take a bite out of corporate profitability, too.

There is more, as in greater government intervention and higher taxes, neither supportive of muscular bulls. Eventually, payment on the U.S. government's massive bailouts will have to be made by the taxpayer. ...

Lesser outbursts of animal spirits already have occurred. At the height of the Internet boom in 1999, for example, during the great bull, the forward price/earnings ratio for the Standard & Poor's 500 index approached 30 times. Later, in the mini-bull of 2003-2007, the market P/E peaked just below 20, in 2004. The next Taurus is likely to see a still-lower P/E zenith. ...

In the course of writing about stock markets over the years, I regularly encountered investors who thought a P/E of 20 was not particularly expensive for run-of-the-mill companies in the S&P 500 that were just barely achieving double-digit gains in earnings per share, and often lower. With less leverage and a stretched consumer, strong growth will be rarer. Investors will still pay up for fast-growing stocks, but the market P/E will reflect a lot of those pedestrian companies and lower growth than in the recent past. For investors, 15 will be the new 20. Get used to it.

Previous	Back to top	Next