Bernie Madoff looks set to be this year’s Grinch, at least for stock investors. His $50 billion ‘Ponzi’ scheme suckered many high-profile institutional investors. And as full details emerge, Frank Hemsley says it could shatter the fragile confidence in the market. This could mean a sharp leg down for stocks before the New Year.
This from Fleet Street Daily:

Often at the end of the year there’s a substantial surge in stock markets. It’s a phenomenon known as the Santa Claus Rally, on account of it occurring between Christmas and New Year. You can see it on this chart.

Some say this rush of buying is to do with people investing their Christmas bonuses. Others say it’s because the market bears are away on holiday this week – or just that there’s a general feeling of seasonal good will and happiness at this time of year.

Whatever the reason for this year-end excitement, it could be off this year.

You see, Bad Bernie Madoff has just thrown a huge spanner in the works. Or, to be more accurate, he threw it in some years ago. It’s just that it was only last Thursday that his spanner really jammed in the gears of the market machine.

Don’t stand too close, because the sparks are about to start flying… and the wheels of the machine could be about to come off. This could be what really starts the next leg off the great bear market of 2008.

It really looked like the stock market was going to end the year on a positive note – that we were in for a decent Santa Claus Rally. Since the low on 21 November at 3,734, the FTSE has staged an impressive rally of 14.5%. It’s the same for the American Dow Jones, which has notched up 13% in the last four weeks.

But now, what could be the largest financial scam in history has begun to unravel. It was designed and directed by Wall Street veteran, Bernard Madoff and his company Madoff Investment Securities LLC. He stands accused of running a multibillion-dollar fraud scheme. In fact, he admitted as much to his two sons, who went ahead and reported him.

When you look at what Madoff did, there’s nothing too sophisticated about it. He took money in from gullible investors, by promising high returns, for little risk. Then he paid existing investors out of funds provided by new investors. It’s your common or garden ‘Ponzi’ scheme or pyramid scam.

The only reason he’s managed to get away with it for so long is that we’ve been in a major bull market in stocks. With this cheery investment climate, people didn’t find it difficult to believe that Madoff was able to consistently deliver returns.

The problem was that when the whole sub prime mortgage time bomb blew up – and the current bear market took hold – investors started losing money. What did they do? They started taking money out of successful positions to pay for their losses. And they started to withdraw from Madoff’s fund. That’s when the scam started to unravel.

What’s particularly worrying about this mess is that Madoff managed to do business with large numbers of prestigious financial institutions worldwide – guys who really should have known better.

Royal Bank of Scotland is in for £400 million, HSBC have a billion-pound exposure and Spain’s Santander Group is in to the tune of £2.1 billion – although not of its own money… the money of clients it introduced to Madoff.

High profile investors were totally sucked in. “Superwoman” fund manager, Nicola Horlick, of Bramdean Asset Management, had 9% of her fund’s assets with Madoff.

“He is very, very good at calling the US equity market.” Horlick once said of Madoff. “This guy has managed to return 1 per cent to 1.2 per cent per month, year after year.”

Not this year, Nicola. And not ever again.

But of more immediate concern to us now is what is this going to do to the markets. So far, the impact has been minimal. The markets have shrugged off the implications. Maybe that’s because investors believe that the Federal Reserve’s interest rate cut later today will win the bull/bear tug of war. Maybe it will, temporarily.

Sooner or later, though, the full extent of this scam will be clear. Investors will start panicking about what other “good time” scams are about to go bad. It will become apparent that Madoff’s sons and a host of other conmen were in on it too (how could the old man possibly have done it all on his own?)

Investors will start pulling their money out of the stock market. That’s when the markets will start their next leg down. That’s when the Madoff effect will derail the Santa Claus Rally.

Source: Derailing the Santa Claus Rally

Make sure you have your stock market hedges in place. Until next time,