Trader’s Narrative

Due diligence has many meanings depending on context. If you pressed me for a definition within finance, I would say it is:

The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship.

If you suffered losses as a result of Madoff’s fraud, then this lesson is extremely expensive. If not, it is probably the biggest gift Madoff has given the world.

As an investor or trader, you have to perform due diligence not on just trades or investments, but also on your broker or prop firm, your bank, your accountant, etc. Each link in the chain is vital. Never assume anything. Check and verify every little detail. As this most recent event has shown beyond a shadow of a doubt, you have to take personal responsibility and can not have the SEC or FBI do it for you.

Madoff’s Ponzi scheme has snared not just wealthy individuals but very large instititutions like Nomura, BNP Paribas, Neue Privat Bank, Santander, UniCredit, Lombard Odier, Royal Bank of Scotland as well as dozens and dozens of fund of funds that allocated portions of their assets under management to Madoff. These institutions supposedly have whole departments full of lawyers and accountants who are given the task of due diligence. Each and everyone of them failed their fiduciary responsibility and will probably be sued by those who experienced losses.

Just out of curiosity, I looked the website for Optimal Investment Services, the hedge fund arm of Banco Santander. Here is a snippet:

Optimal clients were exposed to the tune of 2.33 billion euros or $3 billion US dollars, according to a report from Bloomberg.

What sort of due diligence did they perform exactly? one that didn’t flag a potential problem with Madoff being the broker, custodian and investment manager, all rolled into one? one which missed the fact that a tiny one person accounting firm did their annual audit?

A lot of heads in “due diligence” and “risk management” departments are going to roll.

What a week! These are certainly interesting times we are living through. A bit too interesting for my taste. But we can’t do much about that.

Curious what massive redemption requests can do for a Ponzi scheme - something the SEC and the FBI were unable to do for decades. Madoff had all the blinking red lights you could ask for: a one person accounting team run out of a 13′ by 18′ office, no independent custodian, 1% a month like clockwork, etc.

Here’s a quote from an article in MAR/Hedge on Madoff, explaining his firm’s uncanny profitable strategy of “split conversions”:

…the split-strike conversion strategy is designed to work best in bull markets and, Madoff points out, until recently “we’ve really been in a bull market since ‘82, so this has been a good period to do this kind of stuff.”
Source

Darn right. In a bull market no one needs their money back. The only thing left is for the US government to propose a $50 billion bailout of Madoff’s firm. What’s a few more billion here and there among friends, right?

But we’re not in a bull market. We’ve entered into a unprecedented situation where everything is going down in tandem. Including gold, the supposedly “safe haven”. Well, to be accurate, not everything has gone down.

To find out the only thing that has gone up and to find other interesting links and stories, read on at news.tradersnarrative.com :

• Federal Reserve refuses disclosure request for $2 trillion
• which solitary asset class increased in value?
• Swiss central bank goes to 0.5%
• Madoff stuns Wall St. with biggest fraud
• why investors may have known and invested anyway with Madoff
• DojiSpace - a new free online scanning tool
• stocks with more cash than equity value - free future earnings

Inside Wall Street’s Madoff Scandal

Here is how things be for this week in sentiment land:

Sentiment Surveys
Last week when things looked a little bit brighter, from a contrarian point of view, I wrote:

However, I don’t want to get too excited because it is just one data point. If we start to see a dispirited response to a continuing rally, in the coming weeks, then it will be a tell tale sign that the rally will stick. Otherwise, if we again see sentiment do an abrupt about face, we’re headed down (again).

One data point is just that. And no more after this week’s sentiment surveys. The Investor’s Intelligence survey of stock newsletters returned a slightly increased 25.3% as optimists and a few less bears at 46.2% (from 49.5% last week). In short, sentiment shows that there is slightly more bullisness in the market.

The AAII which measures retail investors shows a similar effect with the bulls at 37.50% and the bears at 39.84%. This is a much larger move to optimism than the newsletter editors. Basically the AAII sentiment is equal - which from a contrarian point of view isn’t good news. Rather than seeing further reluctance from investors and traders to believe in the market as it rises, we are seeing them jump aboard with itchy trigger fingers.

My hunch about a third trendline break may be spot on as sentiment analysis suggests we are headed down (again).

ISE Sentiment
Continues to be mired in a narrow range. Until it breaks out of this contraction phase, it won’t reveal anything worthwhile. This is true for both the equity only ISE sentiment index and the all securities (which includes index option data).

CBOE Put/Call Ratio
The traditional method of looking at the options market continues to throw a curve ball. This week while the market went sideways and dripped lower, the CBOE put/call ratio actually went up from less than 0.72 to 0.90 - does anyone make sense of this? By the way, I’m referring to the equity only data which is usually less noisy.

Volatility
While volatility continues to be at historical extremes the VIX has formed a coil or triangle contraction. A break down from this formation would mean a turn in the uptrend. Until there is a resolution of this range contraction, we have to live with this crazy market.

The volatility is mildly reminiscent of the bull market of the late 1990’s which allowed so many to extract multiples from swing or day trading. So while it can be gut wrenching from the stand point of a longer term investor, to a trader, it is a godsend after so many years of drought.

Wall St. News
The recent arrest of Bernard Madoff can’t be considered anything but a negative event. At this point, the market looks like a centipede with everyone is wondering when the next shoe will drop. How can so called “sophisticated” investors be so “dumb”?

And isn’t it curious that a massive redemption slip fueled by an unprecedented financial crisis unveils a fraud of gargantuan proportions ($50 billion)? 1% a month, like clock work is too good to be true. Why didn’t more people realize that if it seems to good to be true it probably is? How can you invest billions without the bare minimum due diligence?

The only consolation is that historically, mega-scandals like this come at the tail end of bear markets. We only have to go back a few years to Enron, WorldCom, etc. When the tide goes out, you get to see what was scurrying about at the bottom.