In December, investment-grade corporate debt soared over 15% as credit spreads plummeted following a crash in September and October.

If you’re debating an investment in high quality bonds then it’s not too late. The Dow Jones Corporate Bond Index yields 7.04% or 460 basis points or 4.6% more than benchmark ten-year Treasury bonds. Twelve months ago that spread was barely 2%, or 200 basis points. Treasury bonds are expensive while corporate debt is cheap.

When comparing the relative risk-reward scenario of stocks versus bonds, I think high quality debt is the optimal asset allocation choice. Any healing in the markets will start with credit, not common stocks.

Stocks will not lead a recovery in 2009. Though a bear market rally remains highly probable - stocks are up 22% since the November 20 low - risk remains high despite a 40% plunge last year. That’s because corporate earnings have fallen off a cliff since the fourth quarter and consensus estimates for the first half still appear too bullish.

Even in a best-case scenario for stocks, volatility will remain prevalent and that means a box of Rolaids for most investors. Why take a chance on stocks this year amid the great economic “unknown” when you can tap into 7%-plus yields on corporate debt with the scope for big capital gains if bond prices rise? The tradeoff makes sense.

Even the largest financial services companies or banks are now backstopped by the federal government. Spreads on these bonds are even wider than non-financial corporate debt and have the implicit guarantee of Uncle Sam since October. For example, Bank of America’s January 2011 notes provide an effective yield of 6.03% or 514 basis points more than Treasury bonds.

High-yield bonds, or junk bonds, got smashed to pieces in 2008 suffering their worst year on record - down 25%. Junk debt now yields 13.8%, according to the Merrill Lynch High Yield 100 Index. But as the corporate default rate climbs sharply from 3% now to 10% or more this year it’s hard to imagine junk bonds can muster a significant rally. Historically, junk bonds don’t appreciate when the default rate is climbing.

The stock market can continue to rally this year, similar to 1932 when it more than doubled in a short period of time following an 86% crash from 1929 to March 1932. Yet even after doubling in 1932 from March to late June the Dow finished the year down 15%. Talk about a wild market!

It makes more sense to me as an investor to buy high quality corporate bonds in 2009. You get paid nicely to wait for a recovery in bond prices while stocks remain hostage to great economic uncertainty and more, including regulatory changes, rising unemployment, geopolitical tensions and, most of all, a deep bear market in residential housing.

“I could argue either side,” he said, “I could give you excellent data supporting both sides of the debate. I could shower you with charts, graphs and analysis, but in the end, trying to guess where the markets will be one year from now is really impossible.”

David felt particularly discouraged after the Institute for Supply Management released its latest numbers. Bad news, but the markets ended the day up by 258 points. “Maybe it’s not the markets that are confused,” he said, “maybe it’s just me. I would have thought we would see a decline.”

“Trying to guess the direction of the markets on a day-to-day basis is a losing game, but like I said earlier – every market offers up opportunities and this market is delivering us some really great ones.”

“When I’m not sure what direction the market might take in any given day, yet I have money on the sidelines I’d like to put to work, I tend to narrow my research on one or two criteria.”

“If I can find quality stocks that are paying a high dividend and have a low P/E, then I may have found a gem in these markets. When the deal is good enough and I know the company will be around tomorrow… well, then confused markets be damned, I’m in.”

David shared one of his favorite picks for this kind of confused marketplace… “General Electric Corp. (GE) - GE is one of only six U.S. industrial companies with a AAA-rated balance sheet and, with 32 consecutive years of dividend growth, it’s always on my radar screen…but now more then ever.”

“Today with GE’s share price at about $17, its dividend yield is a whopping 7.33% and its P/E ratio is just 8.25, much less then the trailing and future S&P 500 P/E predictions. Receiving this steady 7.33% dividend check gives me the luxury of sitting back and waiting for the shares to appreciate. I don’t have to be in any hurry.”

“If major sovereign borrowers like Germany and the Netherlands are having difficulties raising weekly bond auctions since October,” said Investment Director Eric Roseman,  “imagine what lies ahead for many distressed U.S. municipalities in 2009. The picture isn’t pretty, unless the Federal government under Obama bails out the weakest credits, including California, now in the midst of yet another full-blown budget crisis.”

Having overextended themselves during the boom – just like every other kind of government – the municipalities are now feeling the chill of a global cooldown. And unfortunately, unlike the Federal government, municipalities don’t have the ability to print their own money…leaving them “up a creek without a paddle,” for lack of a better term.

“Earlier this fall, investment grade municipalities, New York and New Jersey, attempted to raise money for the Port Authority, part of the bi-state transportation chain. Despite offering attractive terms on a short-term note, the sponsors scrapped the auction because of tepid interest. Not a bullish sign in times of acute credit stress.”

“I really don’t care about the attractive tax-equivalent yields now offered; fears of rising defaults make holding these securities risky amid a credit crunch. Many cities and towns are now entering a crisis funding environment and unless Obama offers fast relief, a wave of defaults is likely in 2009.”

Continuing with the theme of the Madoff Nightmare – let’s go ahead and get it all over with – today’s Special Comment comes from our resident Offshore Expert, Bob Bauman. As with Snowball in Orwell’s Animal Farm, it seems that the authorities are constantly in need of a scapegoat to justify their questionable attacks on your right to take funds offshore. And Bernie Madoff seems to fit the part perfectly…

As oil broke US$100 a barrel last year on the meteoric rise to US$150, few people were putting the brakes on their investments. Instead, most were too busy coming up with reasons why US$100 was perfectly justified and US$150 a feasible outcome. Investment Director Eric Roseman explains how he, too, bucked the trend and started hedging early in 2008…

“To protect our natural resource exposure in my service, Commodity Trend Alert, I immediately issued a series of reverse-index purchases betting against commodities. We were most successful betting against industrial metals or base metals, as copper and other metals collapsed. That position - still open - has gained 80% since just August of 2008.”

“And since September, CTA has been riding a broad commodity index to the basement as part of our reverse-index strategy - up more than 60% at the moment.”

On the importance of hedging at a time like this, Eric said “Volatility will remain rampant in an uncertain economic environment marked by growing consumer credit woes, weak earnings, and massive government bond issuance to support gargantuan fiscal spending plans. Investors must hold downside market protection.”

And looking back at gold’s performance in 2008, he mused “Gold has also been a strong performer compared to most other assets in 2008. Significantly, gold is the only asset that is outside the credit system and the only asset that has no liability. In 2008, spot prices gained a modest 1% - not much in absolute terms but certainly impressive compared to other plunging assets.”

And his forecast for 2009 was abundantly clear, “This is not the time to be aggressively buying stocks. Odds are, prices will get cheaper again following any bear market rally. That’s certainly been the case every time stocks have rallied off their lows since October 2007. Instead, make sure your portfolio includes gold, portfolio-hedging strategies and income from high quality investment-grade corporate bonds in 2009.”

Especially in light of the mortgage fiasco at the heart of our economic woes, many investors are down on the dollar. Indeed, it seems to be an American pastime to snub the dollar at any possible occasion. And why not? We’ve watched our infrastructure wilt over the last few decades, we’re the originator of this economic downturn, and our government carries an amount of national debt that could only be described as legendary. From a ‘fundamental’ standpoint, the dollar rally overstated the currency’s strength.

But what if those are 2006’s ‘fundamentals’ that everyone’s talking about? That is to say; what if the banking crisis, global credit crunch and subsequent economic downturn have changed currency ‘fundamentals’ for the time being?

“The price of a currency is determined by the supply and demand for that currency. It is that simple,” Jack Crooks said earlier this week. “Now, think about the credit crunch. It was a ‘sea change’ event in the global economy that completely altered the supply and demand dynamics for every single asset class - stocks, bonds, commodities and currencies.”

He went on to explain how money flow is currently keeping the dollar tightly coupled with gold, oil and the stock market, and how everything became so tightly connected. And with several member countries against the wall, he sees hard times ahead for the euro…

“Euro member countries have no sovereignty on monetary policy…and the big member country - Germany - is railing against providing a major stimulus to support the rest of the union members. Why should Germany pay for other countries lack of discipline?

“This is the Achilles Heel of the European Monetary Union - Since member countries have no fiscal responsibility, they can spend all they want and the ECB has no say or power to stop them.”

“This is the first major test of the euro as a currency during a major down cycle…don’t be surprised if it fails.” Even I was a little skeptical after reading this part…but then again, so was everyone else that he told about a dollar rally this time last year…

Think back to the beginning of 2008. If you’re like most investors, you were probably wondering just how low the dollar might fall in 2008, and how much higher oil would surge. But, Mr. Market surprised us in a big way in 2008.

Now the question seems: How much higher will the dollar go, and will oil continue to plunge lower?

Many were so surprised by awesome and swift change of fortunes in 2008. So let’s take a look at some of the reasons for the swift reversal of fortunes for these two major asset classes. There are solid fundamental reasons why the oil-dollar relationship has been so tight, and will likely continue in 2009.

The Secret to Currencies: It’s About Money Flow

I’ve had an opportunity to talk with a lot people about currencies this year. And the most asked question by far is this: How can the dollar rally when the U.S. economy is doing do poorly, to say the least? It’s a good question. Let me explain.

One of the things you must always keep in mind when dealing with currencies is this: The price of a currency is determined by the currency’s supply and the demand for that currency. It is that simple!

Though it can get complicated when we go through all types of analytical gyrations in order to figure out exactly where supply and demand sit. Now, think about the credit crunch. It was a sea change event in the global economy that completely altered the supply and demand dynamics for every single asset class — stocks, bonds, commodities, and currencies.

Let’s look at how these key asset classes acted together during the last market cycle, i.e. before the credit crunch changed everything. If you examine the chart below I think you will see that one key asset class — the dollar — didn’t play well with others. It went down as the other asset classes went up.

The chart below is a bit convoluted, I know. But, it is important to understand because it helps explain how money flow is critical to forecasting the dollar’s path. As you can see below, the dollar index tended to travel in the opposite direction of gold, oil and stocks before the credit crunch hit the global markets in 2007.

Before the World Had Heard of a “Credit Crunch”

2001 - 2007: Gold, Stocks and Oil Hit Multi-Year Bull Market. Notice that each of the asset classes, except the dollar, launched into a multi-year bull market back in January 2001! Back then, Fed, European Central Bank (ECB), and Bank of Japan (BOJ) all juiced the markets with liquidity. At the same time, investment banks added even more liquidity by creating literally trillions of dollars in new derivatives.

Think of this era as a dollar-based liquidity explosion for all asset markets except for the major funding source for all this growth: the U.S. dollar.

Fast Forward to 2008: Now, let’s take a look at this same chart after the credit crunch hit the global markets in 2008. The dollar (red line) bottomed the week of March 10th, then gold (brown line) topped at the same time. By then, stocks (blue line) had already topped. A few months later, oil (black line) also topped in July.

We Watched Gold, Stocks and Oil Top Out While the Dollar Surged

What happened? Why the big change? Money flow! Money poured back into the U.S. as the impact of the credit crunch forced major institutions to deleverage their positions.

The big players were (and still are) fighting for their lives. They had to sell risky asset investments overseas and bring money home. And we’ve also witnessed big repatriation of retail mutual funds back into the United States. In four months thru October 2008, U.S. residents sold a net US$126 billion of foreign securities.

So, this is why it didn’t matter that the U.S. economy was in the tank and getting worse. Money flowed back into the dollar because of the credit crunch! Remember, it is supply and demand.

We had, and continue to have, a situation where the supply of dollars (in the form of trillions in dollar-based derivatives) is evaporating. In other words, we’re seeing a lower dollar supply worldwide. At the same time, we’re seeing a massive decline in global demand as all the major economies are entering what could be a very deep recession!

Where Are We Headed in 2009? Another Big Surprise in the Making!

Unfortunately for most people, I expect global economic conditions to get a lot worse in 2009 before they start getting better. Why do I say this? Because global trade and demand has vanished at an astonishing rate and seems to be accelerating downward.

Consider these facts:

1. In November, Japan recorded the biggest single decline in exports ever; back into a nasty recession and deflation they go!

2. China exports declined in November for the first time in seven years; unemployment is soaring as factories close everywhere in the country; the export model is in jeopardy; social stability is paramount in China at the moment.

3. Global marine shipping rates have fallen up to 95% and more.

4. Plunging energy prices have eviscerated the Russian economy so the government is now draining reserves; major social unrest is in the cards.

5. Spain is in panic mode — ditto for Ireland, Italy, Greece, Portugal, and other members of the European Union.

6. Germany (the engine of euro growth and model of fiscal discipline) is heading into deep recession — latest consensus forecast is 2.7% decline in their economy.

7. The U.K. economy is staring into the abyss; and it looks to get worse.

8. Credit for emerging market nations has virtually disappeared. Export demand for their goods has vanished. They are relying on emergency International Monetary Fund (IMF) loans as a stop-gap measure, but the IMF tap has its limits.

9. The U.S. consumer has finally stopped shopping and is saving. That’s a good thing long-term for capital creation, but it’s a disaster in the short-term because the U.S. consumer is the catalyst for global demand and rising unemployment means no rebound by Mr. Consumer anytime soon.

Governments are pumping up money supply, cutting interest rates, and spending taxpayer money as fast as they can, but it doesn’t seem to be helping much.

This tells me that the major market deleveraging will have to run its course before economies begin to respond. And in a deleveraging phase, as I showed you above, the dollar (the world reserve currency) tends to do well…or at least be supported.

But there is another major surprise on the horizon that I believe will lead the dollar to its next big rally phase — concern that the European Monetary System, which represents the euro currency, will come apart!

The euro is the key currency competitor against the dollar. When the euro does well, the dollar does badly, and vice versa. But as global demand continues to shrink, I expect key member countries — either Italy, Greece, Ireland, Portugal, or Spain — to completely abandon all fiscal responsibilities they must maintain as members of the European Monetary System. And that will hurt the euro.

It makes sense, and here’s why.

Euro Member countries have no sovereignty on monetary policy. That is set in Brussels by the European Central Bank (ECB). And the ECB is woefully behind the interest rate curve. And the big member country — Germany — is railing against providing a major stimulus to support the rest of the union members. Why should Germany pay for other countries lack of discipline?

This is the Achilles Heel of the European Monetary Union — Since member countries have no fiscal responsibility, they can spend all they want and the ECB has no say or power to stop them. They can also spend, as little as they want if it suits their citizens’ needs. In other words, there is a lack of political sovereignty behind the key member states that form the Eurozone, and back up the euro.

In an environment where most countries — and their politicians — are scrambling desperately to provide stimulus to their citizens, I expect several member countries in Europe to abandon their Brussels-based fiscal shackles and break the bank.

If that proves true, it will rattle the foundation of trust and cooperation the euro was supposedly built upon. Trust and cooperation work fine when everyone is making money and growing.

But in the dark days of a downward business cycle, with the wolf at the door, it’s everyone for himself. This is the first major test of the euro as a currency during a major down cycle.

Don’t be surprised if it fails. And if it does, it would be very bad news for the euro and would usher in a whole new wave of money flowing to the U.S. dollar — a wave more-than-likely to trigger a powerful leg up in the greenback.

The Next Direction for the Dollar…

It should be an interesting year. But once again, I’m betting the dollar will rally. Be prepared.

We can answer that quickly. We only write what we see. Too often the mainstream media “parrots” whatever is said by mainstream economists, analysts, brokers and commentators.

Arguably it is their job to provide unbiased reporting.

Unfortunately, most of what they are told by the mainstream is either just plain wrong, misguided or ill thought.

At Money Morning we also offer unbiased reporting. But with a difference. We have no hidden agendas or special interests or lobbying to consider. We are in the comfortable position of being able to see what is happening, think about it and comment.

Importantly for you, we are consistent. Ideologies have been much maligned recently. How often have you heard a politician or finance professional claim that “now is not the time for ideology.”

It is because 99% of modern politicians do not have an ideology that they are unable to offer consistent policies. And it is because most finance professionals have a hidden agenda that they do not adhere to an ideology.

We are fortunate in that we are unwavering supporters of free-markets. It is a simple ideology. The disappointing thing is that free market economics is being unfairly tainted with every ill that is sweeping the current financial markets. We even heard someone over the weekend claim that the Bernard Madoff ‘ponzi’ scheme was an example of free-markets gone wild.

Wrong. Madoff’s activities had nothing to do with free-markets. It did however, have a lot to do with fraud.

But back to my original point. What we like to bring you is the kind of commentary and analysis that you will not read elsewhere.

For instance, until recently I have been and unashamed stock market ‘bear.’ I say until recently, because within the last couple of months I have switched to become a stock market ‘bull.’

Let me explain one thing that you won’t read from any other stock market bulls. I am firmly of the opinion that the current high levels of government intervention, the expansion of credit, and the ignorance of inflation will have a longer term negative effect on the Australian economy and probably financial markets.

However, that doesn’t mean to say that markets won’t rise during 2009. I think it will. I think the majority of the mainstream will consider the massive intervention by governments and central banks as a positive and this will have an upward impact on stock markets.

However, there will be a downside. And as things stand, the biggest threat to the Australian economy and individual savers is the looming threat of higher inflation and a sustained period of artificially low interest rates.

And that is the very reason why investors should now look to the depressed stock market prices as a way to get above inflation returns over the next twelve months. Those that don’t take the plunge and instead choose to stay in cash are in danger of seeing their investment lose value over the same timeframe.

It’s fight night ’09, and tonight’s match promises to be a real slobberknocker.

In the red corner, sporting the white trunks and bad fundamentals, weighing in at US$10 trillion in national debt we have the Dollar bears. The Dollar bears often stick to fundamentals and focus on the overarching picture, though they acknowledge short-term strength in the face of a seemingly insurmountable credit crisis.

And in the blue corner, sporting the gold trunks and Fibonacci analysis, with a keen eye for global capital flows, we have the dollar bulls! A round of applause everyone [the crowd goes wild]…

To give you a quick pre-fight refresher, the dollar bears point to weak fundamentals and a huge amount of debt to say that the dollar is doomed. Meanwhile, the dollar bulls are less idealistic. They focus indiscriminately on the countries and the nuts-&-bolts of their economies. Essentially, the dollar bulls are conducting a “reverse-beauty pageant”…and the dollar’s prospects are looking less ugly than the competition.

In round one, they’ll be trading blows regarding the recent stutter in the dollar rally. If you haven’t been following currencies, the dollar recently fell off a cliff…losing almost all the gains it accumulated in the rally that started this September…

“As you may have noticed, volatility has been humongous in currencies lately,” says Currency Analyst and resident dollar bull, Jack Crooks.

“The huge run in the euro recently seems to have a lot of Johnny-Come-Lately dollar bulls changing their tunes. They’re now suggesting the strong dollar move is done. It’s time for the dollar dirt nap once again, or so they say.”

Is it time for the dollar’s dirt nap? A hard bounce last week suggested otherwise…

“I have searched the news wires this morning,” says Currency Analyst and resident dollar bear, Chris Gaffney, “and I just can’t find any good reasons for the dollar’s bounce other than the dollar had simply fallen too hard, too fast.”

“One of my fellow traders and I were talking about this yesterday morning,” he went on, “as we stared at the trading screens in amazement. The dollar’s move down over the past two weeks was even faster than the move up earlier this year.”

Very true. So what do the bulls say about last week’s rapid decline in the dollar index?

“Honestly,” Jack goes on, “in a market where volatility is spiking to all-time highs, it’s a very tough call to suggest that a multi-day currency move means anything significant.”

“Despite the dollar’s recent drop, our fundamental story hasn’t changed. I still see the dollar rallying into 2009,” Jack said.

“Yesterday’s news is a big part of that dollar story. We learned that China is cutting rates and Germany will contract more than expected.” This is the ‘reverse-beauty pageant’ I mentioned earlier. China, Germany and the rest of the world are getting uglier and uglier.

Jack goes on, “In other words, we’re seeing once again that global demand has evaporated (Japan recently reported that November exports dropped at the sharpest rate on record).”

Is your head spinning just yet? If so, I apologize. But while they may disagree on the dollar’s recent activity, there’s one thing they don’t seem to disagree on…

Trading is a business, but to me, it is also a game. There are winners, there are losers, and there are spectators.

Last Saturday I was asked to help out a friend’s cricket team which didn’t have enough players for a match. I love cricket, but I hadn’t played in five years, so you might say I was unfit and a little bit “out of touch.”

I showed up to the ground feeling more than a few nerves. After all, opening the batting can be tough and even a little dangerous at the best of times, let alone when you haven’t picked up a cricket bat for five years!

Our team dismissed the opposition for a relatively small total, so at least when I went out to bat, we weren’t chasing a lot of runs. The strong wind was causing the ball to swing wildly, so batting wasn’t easy, but I figured I would hang around in a support role and let the other batsmen score the runs. I was sure I would have enough trouble just staying at the crease.

I decided to approach my innings just like I approach my trading – with a plan!

I knew that as a batsman my three best shots were drives, leg glances, and blocks. These are low risk shots, not going to score runs quickly, but not likely to get you out either. There are other, more glamorous shots, like hook shots and pull shots, but these were higher risk, so I decided not to use them in this innings.

This is just like trading. Sure, picking an exact top or bottom can make you look like a hero, but it has also caused some people to “fall in love with their forecasts” and end up wiping out their trading accounts. In cricket, the history books might show a batsman scored 100 runs, but nobody asks if the batsman played stylish cricket or clever cricket or boring cricket. The results simply show 100 runs.

If you make a million dollars from trading, do you care whether you made it by calling exact tops and bottoms, or by trading the swing charts?

In the game, my plan was to accumulate runs and slowly work my way into some kind of rhythm, while assisting the other batsmen.

Our team’s top three batsmen fell with our score only on six runs and all of a sudden what initially looked like a small total to chase was now looking a lot more difficult. I stuck to my plan, but at the same time, I realized that I could no longer depend on others to score the runs for the team. Even though I was out of form, I realized I needed to step up and take control of the situation.

I changed my mindset from being a “supporting batsman” to being a “responsible batsman.” I wasn’t the captain of the team. I wasn’t even a senior player. But in my mind, all that was required for the team to win was for me to perform. I knew that if I kept my head and weathered the storm, my team would win.

Ball by ball, I patiently stuck to my plan. I let the good balls go, and placed the bad balls into the gaps. You could say I was playing with a high probability, low risk, low reward “trading plan.”

Occasionally, I “timed” my shots well and they went for four runs. They were the same shots that would previously score me only one run, but sometimes luck just seemed to send the ball through the gaps and out to the boundary.

That’s just like trading. The same setup might work six times out of ten for you, scoring a small win. Twice it might get you a breakeven, and once a loss. The tenth time, it might make you a huge win.

I ended up batting for the whole innings, until we scored the winning runs with six wickets down. Physically, I was exhausted and could hardly walk, but mentally I was pleased with myself, because I had overcome a challenge. I had played a “Captain’s Knock,” even though I wasn’t the captain.

When you are trading, there are no team mates out there to help you. Sure, you can contact a Trading Tutor, but ultimately your success or failure rests with you. Don’t see it as something intimidating – see it as a challenge to bring out the best in you.

Whether you are batting or trading, set yourself a mental challenge of performing to the best of your ability. As David Bowden says, “make each trade your personal best.”

Work out the trades that are likely to return profits to you, and not likely to “get you out”. In cricket, the saying goes that if you stay at the crease long enough, the runs will come.

The same goes in trading. If you protect your capital and stay in the game long enough, your profits will come.

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There’s no doubt that 2008 will go down in history as one of the worst years on financial markets. In Australia the bourse has dropped by around 45%, making this the worst calendar year in more than 50 years.

But that doesn’t mean that all stocks have done poorly; in fact there have been a number of great success stories over the past 12 months. Indeed there have been over 70 companies on the ASX that have gained ground since the start of the year, the best being Altera Resources which has climbed over 1800% higher! But even if we look only at stocks with a market capitalization of more than $500m, there have still been some great performers.

Of course, hindsight is a wonderful thing, and even though most of us would have missed out on many of these wins, there are nonetheless some valuable lessons we can draw from these examples.

One thing that stands out is that most of these companies belong to the energy sector – even though oil has tumbled from almost US$150 / barrel to less than US$40 / barrel in the past 5 months. A big part of the explanation is the revaluation of coal seam gas assets, and the slide of the Aussie dollar, but in this regard both of these factors would have been difficult to forecast.

However the other thing that most of these companies have in common is conservative gearing levels and quality assets. Factors that were largely ignored by investors prior to the credit crunch, but are now being closely watched.

There’s no coincidence that companies that have minimal debt refinancing obligations and solid balance sheets have been the ones to do well in the current environment. Indeed, those at the other end of the spectrum, have been those with very high levels of debt, and assets that have plummeted in value.

Consider the worst performing stocks with a market capitalization of more than $10m.

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Who has heard the expression “dropping your pants”?

Everyone. Thought so.

Well, that’s what the Federal Reserve has done this morning. It has taken the momentous decision to drop the Fed Funds Target Rate to a maximum of 0.25%. Almost everyone expected them to do that, so that part of it wasn’t a surprise.

The big surprise was what else they have done with the rate. Having seen that the market was pricing interest rates well below the target rate, the Fed has thrown up its hands.

Instead of setting a specific rate, such as the 1% that it was before, the Fed has set a ‘range’ of 0%-0.25%. In effect they are challenging the market to take the rate down to zero.

The Fed conveniently publishes the daily rates on its website for all to see. You can see a snapshot of it below:

Even before the rate cut, the market was trading well below the 1% level. Chances are that over the next few weeks we will see the rate drop to zero. In which case the only option left for the Fed is to print money, and the inflation race begins again.

But that wasn’t all the Fed had to say. No, there was much more.

The press release states:

“As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”

In other words it is going to take the place of the discredited and dysfunctional Fannie Mae and Freddie Mac. Only this time it is upping the ante by not just providing capital for the mortgage market but it will also provide capital households (credit cards and car loans we presume) and small business.

But that wasn’t the end of its generosity either…

The Fed’s Hidden Gift to US Banks

We aren’t sure if this final gem from the Fed was shuffled out quietly into the market or whether they had always intended to make the announcement today.

First a bit of background. As you may be aware, banks have to maintain something called ‘Tier 1′ capital. In simple terms it means they need a certain percentage of liabilities backed by hard assets - usually government bonds or foreign exchange reserves. Australian banks have been raising capital recently to keep their Tier 1 at around 8%.

Well, news from the US Fed this morning is that US banks are now able to be more flexible with their Tier 1. The new rule means they no longer have to discount goodwill from the calculations for Tier 1.

In other words, banks can now use intangibles such as the value of a brand name as ‘hard’ capital against its liabilities. In effect, the Fed is moving the goalposts. It is saying that it knows the banks are up a certain creek, so rather than call them out on it; it is changing the rules so that the banks can look stronger than they actually are.

After landing at Vienna International Airport last Friday, my colleague and good friend at an Austrian private bank informed me of the Bernie Madoff hedge fund scandal. I was truly shocked and disgusted.

Approximately US$50 billion has been lost in the biggest hedge fund scam in history. Though it’s still too early to ascertain exactly how much, if any, investor capital will be recovered, the odds are pretty high that most Madoff investors won’t see a nickel.

How can someone knowingly rip-off his investors, including his own son, friends and large international investors year after year without any remorse, no shame? This is truly unbelievable.

How can Bernie Madoff live with himself?

The damage done by this scandal will add even more insult to injury for the hedge funds. The industry is now suffering its worst public relations disaster since the Bernie Kornfeld IOS scam in the early 1970s. Hedge funds are estimated to have lost about one-third of their total assets in 2008 and now more investors will probably run for the exit following this huge fraud.

Madoff ran several offshore and domestic hedge funds specializing in something called “option arbitrage,” a strategy I barely understand let alone would ever attempt to trade. Big institutional investors in Switzerland, Austria, Israel and elsewhere have suffered major losses following revelations last Thursday by Madoff that his entire hedge fund business was “one big lie.”

A classic Ponzi scheme, Madoff Securities would raise capital from new investors and then pay existing investors who redeemed. It was a massive gamble that worked for more than ten years, producing low volatility returns while rarely recording a losing month. Investors with Madoff earned about 10% per annum in his hedge funds.

The jig was up for Madoff starting in November when a rash of redemptions overwhelmed his business (or Ponzi) model. Many top performing hedge funds this year have unfortunately been victimized by a global liquidity crunch, including Madoff.

I actually reviewed one of Madoff’s prospectuses about three years ago. I was initially lured by his consistent returns; but after reading the prospectus, I determined that I didn’t understand his strategy and decided not to invest.

If you don’t understand an investment strategy - no matter how seemingly spectacular the returns - then avoid it. Yet amazingly, some very smart investors, including several I know personally, have now lost millions with Madoff.

In the end, institutional and individual investors alike failed to conduct their own due diligence on Madoff Securities. Perhaps it would not have made a difference anyway.

I make it a point to travel and meet my advisors, conduct rigorous due diligence and ensure that I truly understand the investment strategy. If not, it’s “see ya later.” I also look to see how a prospective manager performed amid market carnage or big systemic-induced declines. If a manager consistently makes money under extreme market volatility then you’ve got to ask what kind of strategy can produce that sort of absolute return. This was the case with Madoff.

You’ve also got to wonder what Chris Cox at the Securities and Exchange Commission (SEC) does at work every day. This guy is a joke.

Regulators last performed a review of Madoff Securities in 2006; what were these guys doing at the SEC? It’s unimaginable that the nation’s regulator didn’t catch this fraud, especially considering that Madoff was overseeing $50 billion in assets.

As a side note, Madoff did make regular political contributions to several parties. I’m not sure what role, if any, this played in lax oversight.

But the first thing in January I would do if I was president-elect Obama is to purge the SEC. Cox must be fired. The SEC is totally out of control with no oversight…and in my book gets a massive “F” for failing to properly regulate the entire securities industry.

It is being labelled as the biggest Ponzi scheme the world has ever seen.

What is a Ponzi scheme? A Ponzi scheme is a simple yet illegal way to pay out early investors with money deposited by later investors. That’s how they can guarantee high ‘returns.’

Investor A puts in $100 million. Investor B puts in $100 million a year later. $10 million of investor B’s money is used to pay investor A, giving him a 10% return.

Investor C puts in $100 million. $20 million is used to top up investor B’s account plus extra to give him a 10% return.

You can see how easily it can get out of control. Yet as long as new investors are prepared to invest then the scheme will ‘work.’ And who wouldn’t be prepared to recommend Mr. Madoff to their friends? After all he’s returning 10% a year.

Why have I used such large numbers to illustrate the point? Well, unlike what we saw here with Chartwell, where most of the investors were relatively small, the clients of Mr. Madoff were big. Very big - Hedge funds, institutional investors, ultra-wealthy individuals.

So big that it is estimated total losses in the scheme will exceed USD$50 billion.

Take a look at the list on Wikipedia of some of the firms that have been duped. It includes the likes of BNP Paribas, Banco Santander and Nomura Holdings.

The best bit about this story is Mr. Madoff’s pedigree. He is an ex chief of the NASDAQ market. Looks like a remnant of the dot-com years has come to bite the market on the backside again.

Is there any chance of this happening here?

As mentioned before, it already has on a smaller scale. But you could argue it has happened on a larger scale too. The infrastructure funds that have gone pear-shaped recently can be viewed as a type of Ponzi scheme.

The infrastructure funds were borrowing against future cash flows in order to pay current investors. That isn’t a million miles away from how a Ponzi operates.

The unfortunate part of the Australian experience was that most investors were small retail investors who had been lied to by planners and investment bankers who claimed that these funds would offer secure and reliable income (plus growth!) into retirement.