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Jeff Saut: Expect Further Embezzlement


This crime is unique in that it's only uncovered after a period of time.

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country's businesses and banks. This inventory – it should perhaps be called the Bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed
--"The Great Crash of 1929" by John Galbraith

Mark Twain once opined, "History doesn't repeat itself, but it often rhymes." Nowhere is this truer than in the stock market because it is mainly a combination of fear, hope, and greed only loosely connected to the business cycle. As Nobel laureate George Akerlof argues, "Individuals can act irrationally and for non-economic reasons." Indeed, at the margin, stocks are driven by human emotions; and over the years human emotions have not changed all that much, as can be gleaned from the Galbraith quote. To wit, "Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery." Those who go on to read the book find that following the 1929 crash came the most spectacular "bezzle" of the period. It was the looting of the Union Industrial Bank of Flint, Michigan. "The gross take, estimates of which grew alarmingly as the investigation proceeded, was stated in The Literary Digest later in the year to be $3,592,000 (December 7, 1929)." Regrettably, following the discovery of this initial bezzle came a string of bezzles that created a negative feedback loop in crowd behavior and human psychology that impacted the various financial markets.

Fast forward to present day. While there is no specific definition of a stock market crash, the term commonly applies to a double-digit percentage decline in a stock market over a few days. For example, in 1987 the DJIA lost 22.6% in just one day; and in 1929 it lost 23% in two days. Therefore, by my pencil, we have not experienced a stock market crash, but rather a series of mini-crashettes. Still, it certainly feels like a crash, return). As of last Friday (12-12-08), the S&P 500 is down 38.7% YTD. Thus the S&P 500 has fallen 28.6% in the last 100 days, a performance that would rank as the 6th worst bear market of the last half century." Unsurprisingly, following such a downside skein, comes news of "the bezzle" whereby Bernie Madoff's ponzi scheme came unraveled to the detriment of many investors.

Manifestly, only when the tide goes out does one discover who's been swimming naked. Unfortunately, if past is prelude, like in the 1930s there will be more "Mr. Madoffs" in the coming months, which should lead to increased negative investor psychology combined with massive Congressional hearings resulting in more wrong-footed regulations like the Sarbanes-Oxley Act. While this is likely the course we are steering over the coming quarters, the real question becomes, "Have the equity markets already discounted such events?"

In past missives we have suggested that the equity markets have been in a bottoming process since the October 10th capitulation "low." We have given numerous metrics for that view, but in this week's Barron's the always insightful Stephanie Pomboy makes our prose pale in comparison when she states:

"In the very near-term, there are a variety of reasons to anticipate a rally in risk. First is the massive destruction witnessed to date. Our dogmatic [insistence] that markets needed to give back all the gains built on the housing-bubble lie have largely come to pass. Virtually every market is at or near pre-bubble lows, from stocks to bonds to commodities... [so] the financial deleveraging may largely be complete (see the nearby crude oil chart). Most notably, yields on corporate credits have climbed to multidecade (and in the case of junk, record) extremes. At the same time, cash [must be] burning a hole in investors' pockets with 0% yields before inflation and dollar debasement."
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