Madoff Scandal A Microcosm of Social Mood

The controversy surrounding Bernard Madoff and his hedge fund scandal is a fascinating one, and I simply can't let it go without throwing in my own two cents.

For a backgrounder, take a look at Losses in Madoff Case Spread from the Wall Street Journal.

It seems like nearly everyone was in on the action. High profile charities, investment moguls, funds of funds, and major investment branches of European banks. Santander, BNP Paribas and the Royal Bank of Scotland are some of the bigger names taking hits. The total estimates of losses range from $17-50 Billion Dollars. This isn't chump change.

But what I find most amazing is the sheer stupidity and ignorance that investors in Madoff's funds displayed even as they knew that he couldn't possibly be providing the advertised returns with the published investment strategy. They all just trusted him, shrugged their shoulders and said, "Let the money keep rolling in." They didn't care where it was coming from. Please consider: I knew he was cheating. That's why I invested with him.

What could possibly bring a person to such incredibly flawed logic? Greed is the easy answer. But inflation is the real culprit. Desperate to provide a rate of return higher than inflation, investors were willing to do anything. They would give their money to the most undeserving people who could simply write a good proposal. No further investigation was done. Not even by the fancy investment bankers and their 6 (or 7) figure salaries. The higher the risk, the higher the return. That was the only language they understood.

But what interests me most about this recent development is how it aligns perfectly with socionomic and generational theory. In an unravelling or a period of high social mood (early-mid 80's until 2007) people are characteristically willing to take on higher levels of risk. They are willing to do anything to impress their neighbours or their friends. But as social mood naturally begins to ebb, and as a new generation rises to prominence, something changes with these attitudes. A rising level of skepticism of the previous era takes hold and it's values are rejected.

These kinds of events feed off each other. From personal experience, I know that when you see a cockroach, you have cockroaches. There will be many more Bernie Madoffs. It was not his incredible arrogance or greed that allowed this to go on for so long. Rather it was the social atmosphere of neglect that led nobody to question it. Until now. Now people are starting to ask questions. Is my mutual fund invested in what they say it is? Are they invested in the real asset, or in a derivative of that asset? How else did they manage such great returns?

This type of questioning leads to the inevitable social contempt of the entire investment world. "Ah to hell with it. They're all crooked," says the average investor as he writes his letter of withdrawal. Increasing political pressure will be put on pension funds to invest in "risk-free" securities only. Astute investors are graded on the proportion of their cash holdings, rather than their investments. This is the backdrop to the next leg down in the stock market that socionomic and generational theories are telling us will be coming with absolute certainty. Such a drastic change in social mood cannot be reversed quickly. It takes time for old wounds to heal. Disgruntled perceptions to forget. Balance sheets to be repaired.

This is why all efforts by government to "get credit moving again" or to provide "economic stimulus" are guaranteed to fail. Our collective social mood is not in a position to reverse. It wants blood. It wants to clean out the old excesses. It wants people like Bernie Madoff to point fingers at.

And that is precisely what we will get. But in the meantime, we have a Santa Rally to tend to. People are still willing to pretend that our problems are all behind us and that "the news is worst at the bottom." They're willing to ignore horrible reports like:

Corporate, Government Borrowing Drops 75% in 3rd Quarter.
Chinese Industrial Output Growth Slowest Since 1999; Electrical Output falls by 9.6%
Japan Business Sentiment in Biggest Dive Since 70s

After the New Year, I wouldn't be surprised to see these negative reports start to make an impact again. Combine that with Q4 earnings that are going to be terrible (note estimates were reduced from +10% to +5.9% last week) and a slowing optimism that Barack Obama will be able to make it all better, and we will have a recipe for another January swoon. But we'll have to see. I'm typically early to major turns in the market. I'm watching a few technical levels to see what kind of legs this rally may or may not have.

All the best,