Madoff pops the hedge-fund bubble

Madoff pops the hedge-fund bubble... Another Madoff scandal... Goldman Sachs, Best Buy show us the way... The healing power of theft... Oil price prediction: $25-$150... Drunks in the mailbag...

The Madoff scandal is the pin in the hedge-fund bubble and another dent in Wall Street's reputation.

Madoff's $50 billion (or more?) fraud deals a major blow to the "fund of funds" industry, which the WSJ claims accounts for nearly half of all investment in hedge funds. Fund-of-funds companies sold investors on diversification, access to hotshot hedge-fund managers, and (believe it or not) superior due diligence.

In a piggyback scandal to the Madoff mess, money manager J. Ezra Merkin charged clients 1.5% to put all $1.8 billion of their money in Madoff's hands.

Madoff's name comes up only twice in Merkin's offering documents, and then only as a prime broker. On page 12, Merkin, who also happens to be chairman of GMAC, tells investors the partnership will "make investments through third-party managers, using managed accounts, mutual funds, private investment partnerships, closed-end funds and other pooled investment vehicles (including special purpose vehicles), each of which is intended to engage in investment strategies similar to the Partnership's." (Italics added.)

Of course, the partnership's strategy turns out to be identical to Madoff's. Merkin obviously set up the partnership to lead investors to believe he was managing their money, while fully intending to give it straight to Madoff from the start. I'm sure Merkin was only lying to his money-management clients. I bet he tells the truth every minute when he's running GMAC.

As for the actual strategy Madoff and Merkin claimed to be using, it's stupid. You buy S&P 100 stocks, then sell calls and buy puts against the position. I don't care what the sophisticates say about this pure exercise in commission generation, anyone who believes his account can go up every month like clockwork is practically begging to be defrauded.

One hedge fund actually seems to be growing. Renaissance Technologies, the super-secretive quant fund run by former math teacher James Simons, is expanding its New York office. The fund is subletting another 6,700 square feet in its midtown Manhattan office building, bringing its total space to 40,000 square feet. Renaissance must have been short stocks and long Treasuries. It's hard to think of anything else that worked this year.

Speaking of hedge funds... The mighty Goldman Sachs today reported a fourth-quarter $2.12 billion loss, the first since going public in 1999. The $4.97 a share loss compares to a net income of $3.22 billion, or $7.01 a share a year earlier. The stock jumped 12% today.

To help stem losses, CEO Lloyd Blankfein and six deputies surrendered their bonuses this year, and the average pay per employee dropped 45% to $363,650 a year. Bonuses? On a $2 billion loss? How exactly does that work?

Another economic bellwether, electronics retailer Best Buy announced earnings today. The company earned $0.35 a share, beating analysts' estimates of $0.24, and revenue grew 16%. However, comparable-store growth (a measure for stores open at least one year) fell 5%, and the company expects another 1%-5% fall for 2009. Best Buy hasn't announced layoffs yet, but it offered to buy out every one of its corporate employees. Shares jumped nearly 16% on the news.

The Supreme Court decided yesterday companies that sell "light" cigarettes can be sued for fraud. The plaintiffs don't want help with their medical bills. They just want their money back because they claim they overpaid for cigarettes based on untrue advertising that light cigarettes were safer than regular ones. It's a fact that light cigs have lower levels of tar and nicotine, but smokers make up for it by smoking more, puffing harder, and inhaling deeper (like that's something the cigarette company has any control over).

Further demonstrating the government's belief in the healing power of theft, New York Governor David Paterson wants to charge a 15% "obesity tax" on high-calorie soft drinks like Coke and Pepsi, while exempting the diet versions from the new tax. A number of states have sales taxes on soft drinks and other fatty foods, while most other foods are tax exempt. New York would be the first state with a tax specifically distinguishing between "diet" and "non diet."

Though forecasting is a fool's errand, Francisco Blanch, Merrill's head of global commodity research, shouldn't do too badly with his oil predictions. On November 26, Blanch called for oil to hit $25 a barrel in 2009. Now he says, "If we reignite economic growth to a very fast level, we will have a shortage of energy again," sending oil to $150 in two or three years. So oil could be anywhere between $25 and $150 in the next two to three years. Write that down...

New highs: none.

As you can see below, the mailbag was full of kind notes. Have you all been drinking? If you have something to say, let us hear it at feedback@stansberryresearch.com.

"Mr. S., I've been following your advisory and those of your colleagues since your 'pirate investor' days and I'm very grateful for the service you provide. Your analysis is candid and actionable, and your commentary pithy. There's a lot of crap in the investing marketplace, but I have come to trust you and your friends at Stansberry. I will retire in a few years at a young age, and in large part, I have you to thank. In a declining republic, there are signs of hope for rebirth. Keep up the great work – I look forward to sharing a libation or two one day with you and the good people in your shop." – Paid-up subscriber LAF

"Porter, you and your analyst's just keep on writing about your families or personal stuff. Steve, I'm sorry to hear of your loss, I remember how I felt when my mom passed away. And Porter, the next time you crash your car, go ahead and confess to us, that even you can sometimes make a mistake. These little tidbits just show's you're real people, just like us and keep giving us timely advice on how we can make money in these crazy markets. Last week, I took the bait on your Put Strategy and as I read your thoughts on the subject and saw your recommendation, I jumped online and did my own research. I saw that the options had closed at $3 which was at the top end of the reco, so I looked at other options and decided that the $7.50 put would give me a good a return, so I placed my order and the next morning it gapped higher and I didn't get filled. Oh Well Mr. Kirkpatrick, sometimes it just happens that way, doesn't mean the reco was bad, it fact it goes to prove Porter was spot on and you don't hear me complaining, so what I didn't get this trade, there will be others.

"And then there are other reco's like Jeff's from last week on silver, I was able to get into the trade, at his price points and was filled with a $0.05 credit, got to love getting paid to make a trade, so based on my margin requirement I'm up 144% and I haven't even factored in the premium for selling the third leg of that trade, so Jeff thanks for yet another winner. As for Mr. Day, my mother always told me, if you don't have anything nice to say, sometimes it just better not to say anything at all, so you go right ahead Porter and rip this guy a new one, he deserves it." – Paid-up subscriber Paul Gilbert

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Regards,

Dan Ferris

Medford, Oregon

December 16, 2008

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