In the wake of the largest swindle Wall Street has even known, everyone is questioning how this could have happened. How could anyone run a 50 billion dollar Ponzi scheme right under the SEC’s nose? The SEC, with virtually limitless resources, has the power to do essentially whatever it wants when investigating fraud. So how could they miss this? Is this just a failure of the free market, an example that those hedge funds just have too much freedom, and government regulators need more power and resources? Not at all – in fact, quite the opposite.

This is a wake up call for investors and the public. Where the SEC failed to spot a problem, the free market saw it. Eighteen months ago, a firm named Aksia run by Jim Vos and Jake Waltour, warned clients not to do business with Bernard Madoff’s investment fund. Aksia is what’s called a due-diligence firm, and they’re an example of what regulation would look like in a true free market.

Because of the lack of government regulation in hedge funds, these due-diligence firms emerged. Investors wanted to be assured that their money was going to a reputable fund, so these companies thoroughly investigate hedge funds for a fee.

Since these firms are operating in the free market and competing with one another (as opposed to the SEC, which has a monopoly on the business of regulation), they have incentives to do the best job so that they gain the best reputation in the business, thus increasing their customers and their wealth.

And Aksia was thorough; they found a number of red flags in Madoff’s fund during it’s investigation, including:

1. The Madoff investment strategy, called “split-strike conversion,” is known to be very volatile; it involves trading huge positions around options expirations. Despite that volatility, its returns over the past decade were an amazingly stable 8-10 percent.

2. Aksia discovered a 2005 letter to the Securities and Exchange Commission from a financial advisor who supposedly studied Madoff’s operations. That letter asserted Madoff was running a Ponzi scheme. There was also a Wall Street Journal story at the time about one of the Madoff’s associated “feeder funds” getting shut down in 1992.

3. Madoff’s strategy was bizarre: He said he would move $13 billion in various trades at once, yet Aksia couldn’t find traders who saw his trades. There were also no regulatory filings. And family members were running the firm.

4. The comptroller of the firm was based in Bermuda. Most mainstream hedge fund investment advisers have their comptroller in-house. Madoff’s so-called feeder funds, meanwhile, were audited by respectable auditors. That gave the impression that Madoff had a professional operation. But the central investment action wasn’t with the feeder funds, but in Madoff’s New York City headquarters. And those activities were audited by a smaller, lesser known firm.

5. Madoff sent out accounting statements by mail. Most hedge funds email statements and allowed them to be downloaded via computer for easier analysis by investors.

6. Aksia wasn’t the first firm to check out Madoff’s activities. A two-man shop (not counting the secretary) which operated out of a small office in Muncie, N.Y., was also looking into Madoff’s activities.

So whats the moral of this story? The SEC simply cannot protect investors as well as free market systems can. The SEC failed to protect investors from mortgage-backed securities and credit default swaps and collateralized debt obligations – and now it failed to notice a $50 billion dollar Ponzi scheme masquerading as a hedge fund. Unfortunately, some people will see those facts and come to the conclusion that we just need more regulation and the SEC needs more resources.

The SEC failed because it’s a centralized monopoly, it’s that simple. And Bernie Madoff’s scheme succeeded because investors had a false sense of security in that bad system and it’s regulations. Take away that monopolistic regulatory giant, and a system of due-diligence firms would spring up to take it’s place. That type of decentralized system of competing firms is many orders of magnitude better at finding fraud and protecting investors; and it’s been proven so. It would be less expensive and more efficient than the SEC, and it would lower taxes and place the financial burden on the actual investors instead of the entire US population, including non-investors.

It’s just common sense.

If you’ve been following along this financial crisis, listening to Common Sense investors like Peter Schiff and Jim Rogers; and keeping an eye on the commodity markets, you know that gold is where to be right now.

But it isn’t as easy to invest in gold as it is to invest in the stock market proper. Many people don’t even know where to start. And if you search online for information about investing in gold, often you’ll only find websites talking about benefits or disadvantages of investing in gold; without any black and white facts on how it’s done. Well, here you are:

How To Invest In Gold

Aside from the futures market, there are 4 major ways to invest in gold: 1.) Digital gold currency; 2.) Direct ownership in gold bullion, coins, or certificates of ownership; 3.) Owning stocks in gold mining companies, or mutual funds consisting of gold mining companies; and 4.) Owning Gold ETFs (exchange-traded funds).
Let’s start with the simplest method, and go from there.

Gold ETFs

Gold ETFs are the simplest and most attractive form of gold investment for many people. It’s basically an investment in gold that’s 100% backed by physical gold held in some allocated form, and traded on the market like a single stock. They were invented to give private investors the ability to own gold and gain exposure to the price of gold without the inconvenience of storing bullion or opening a futures account.

So Gold ETFs are the user friendly version of gold investments, but there are a few drawbacks. First of all, since it’s a fund, it needs to be managed by someone, and that person or company wants to get paid, so there are fees to these ETFs. The upfront commission is typically about 0.4%, and there are also storage fees, insurance fees, management fees, etc. Those added expenses can pile up and put a dent in your investment down the line.

A more frighting, although less likely, aspect of owning Gold ETFs (the funds based on the US, at least) is the prospect of having the allocated gold confiscated by the US government during a financial crisis. This actually happened in 1933, and can happen again anytime the government so decides.

Examples of Gold ETFs:
SPDR Gold Trust – GLD
Central Fund of Canada Limited – CEF

Gold Mining Company Stocks and Mutual Funds

Investing in gold mining companies and mutual funds made up of them is an indirect way of investing in gold. This type of investing is generally more complicated than simply investing in gold. You have to take into account all of the aspects of that particular company: Is it profitable? Stable? Does it offer dividends? etc. Investing in mining companies is inherently higher risk than buying gold directly. Gold mining stocks can be 3 to 4 times more volatile than gold itself, so many investors try to offset that volatility by investing in a mutual fund made up of many different mining companies.

Examples of gold mining companies and mutual funds:
Individual company stocks:
Newmont Mining Corporation – NEM
Barrick Gold Corporation – ABX
Mutual Funds:
Market Vectors Gold Miners – GDX

Gold Bullion, Coins, or Certificates

This option probably seems like the most difficult to the majority of regular investors, but it’s actually the least expensive way of investing in gold, since the brokers commissions are so low. Bullion coins are minted in inexpensive and easy to manage weights like 1/20 oz, 1/10 oz, 1/4 oz, 1/2 oz, and 1 oz (about 31 grams). But if you get gold coins, remember that the price isn’t the face value of the coin, it’s based on the spot price of gold and will change over time.

You can also get gold bars in very small sizes. In Europe, many regular retailers sell ChipGold, which is a small, vacuum-sealed gold bar in a credit card shaped package available anywhere from 1 gram to 1 ounce. The Union Bank of Switzerland offers the kinebar, which has a hologram imprinted on the reverse side of the bar, and is sold in a similar credit card shaped package as ChipGold.

Places to buy gold direct:
eBay
The Perth Mint
If you’re interested in gold certificates, then the Perth Mint Certificate Program is also essentially the only game in town.

Digital Gold Currency

This is the newest and most interesting form of gold investment. It’s a form of electronic money that’s based entirely on gold. Typically, each unit of currency is based on the gold gram or the troy ounce, although many other units can be used. Digital gold currency is backed by gold through unallocated or allocated gold storage, just like the US dollar was pre-1933.

I think this method has the highest potential for future use. It could potentially become a new gold-backed currency in widespread use. Highly recommended for Common Sense Investors.

Some Digital Gold Currency providers:
e-gold
GoldMoney

The real problem in the US isn’t that people can’t afford health insurance, it’s that they choose to spend their money in other ways. Roughly 45% of all uninsured people could afford insurance right now if they wanted it. But it would mean spending less on cigarettes or Friday nights, so they choose not to get it. It’s simple economics, people are using the funds they have and prioritizing what they want. You simply cannot have everything you want.

Politicians aren’t going to get votes if they tell people to change their lifestyle though, so they tell people they’ll solve all their problems for them. This is how politics works, unfortunately, and it’s why we’re in the economic position we’re in today. Think about it, be a Common Sense Investor…and a Common Sense citizen.

The Financial Times interviewed Jim Rogers in late 2007. They were trying to get an idea of where he thought the US economy was headed in 2008 and beyond. He makes some very insightful comments about Ben Bernanke, the FED, and the recession on the horizon.

We have a complete transcription of the interview after the jump, enjoy:

FT: You said you’re selling US assets. So what makes you so bearish on the dollar?

Jim Rogers: Well the US dollar is a terribly flawed currency. As recently as 1987 the United States was a creditor nation. We’re now the largest debtor nation the world has ever seen in only twenty years. We owe the rest of the world over thirteen trillion with a “T” US dollars. That’s a bad number, but what’s worse is our foreign debts are increasing at a rate of one trillion dollars every 15 months. It’s simple arithmetic at how fast it’s going to go up, but its pretty terrifying arithmetic. I don’t want to own a currency which is being debased that way. The central bank in America has said that they’re going to print as many dollars has they have to drive down the value of the currency. The secretary of the treasury is trying to drive down the value of the currency. I mean it doesn’t take a genius to figure out that it’s a currency that’s going to be going down for some time to come. They want to debase the currency. The head of the central bank has been printing money since he got there for two years. He’s printing money very rapidly now, especially since this summer. This is a man who his whole intellectual career has been spent studying the printing of money. Now America is giving the printing presses. I don’t want to be in a currency like that.

FT: So what’s your assessment of Bernanke’s performance so far?

Jim Rogers: Well it’s been a disaster.

Did I make myself clear? He’s been a disaster. I mean he’s been printing much too much money, since the beginning. Last summer he bailed out his friends on Wall Street, said there was some kind of problem. I mean the stock market was down 6%. If a 6% decline in the stock market causes the man to go and cut interest rates by a half a percent, when inflation is running rampant, when the dollar is under pressure anyway, what’s he going to do when the market is down 36%? What’s he going to do when they have a real crisis? I mean he’s going to print money until we run out of trees! I don’t want to own US dollars in an environment like that. I don’t know why you would. I don’t know why anybody would.

FT: So is the US already in a recession?

Jim Rogers: In my view yes. We know that housing is in worse than recession. We know that automobiles are in worse than recession. We know that many parts of the financial community are in worse than recession. We know that machinery — Caterpillar Tractor, one of the largest machinery companies in the world, has said it’s the worse they’ve seen in 50 years. There are a lot of sectors of the American economy that are in serious trouble, shall we say. The government says it’s not a recession. I’d like to know from them, what’s keeping it up, that if all these other sectors — and you know housing and automobiles are two of the very largest sectors — what is not in recession? Retail sales are down; I could go on and on.

FT: So what’s next? What do you think is coming?

Jim Rogers: Well for the dollar? Well probably the dollar is going to have a big rally about now, because everybody in the world is short the dollar. In my experience in the investment markets, when everyone is on one side of the boat, you’d better think about going to the other side of the boat for a while. I suspect there’ll be a rally; I have no idea what will cause it. And if there’s a rally, for a few weeks, a few months, I would urge you to sell that rally — that’s my plan — to get the rest of my money out of US dollars.

FT: You’ve actually been bearish on the dollar for more than a decade. So why are getting headlines now? Is it to do with promoting your new book?

Jim Rogers: I didn’t know I wasn’t getting headlines, you called me, I didn’t call you. The dollar has been steadily going down, as you know, for several years. It’s not been a wonderful place to be. I have no idea. Maybe it’s because now the dollar’s starting to crescendo a little bit more. And actually now that I think about — I don’t think it has anything to do with me — as you probably know, the dollar has never gone below 80 as an index, which is a federal government report; it’s never gone below 80 in the history of the world. Until the last two or three months, when Bernanke started printing all this money and cutting interest rates; in a terribly inflationary environment he was cutting interest rates. It’s broken below that level, so it’s now going to the lowest level in history. So maybe that’s why more and more people are starting to pay attention to the dollar.

FT: You’re known for being apolitical. Are you backing anyone in the next year’s US presidential election?

Jim Rogers: Well, yes. A pox on both of their houses, as far as I’m concerned; the Democrats and the Republicans. I rarely if ever pay much attention — I always vote – but I don’t pay too much attention to them, because I know they’re pretty hopeless. However in this election, if Ron Paul gets anywhere near the nomination, I will certainly support him. I mean he’s the only one I’ve seen in American politics that seems to have a clue about what’s going on in the world.

FT: Will he win?

Jim Rogers: If I’m backing him, there’s no way, no way I assure you. Poor Ron.

If there is anyone who’s even more clear-sighted about finance than Peter Schiff, it’s Jim Rogers. He’s a legendary investor, founder of the Quantum fund, and a highly respected financial commentator, moreso in Europe and Asia than in the US.

This video is an interview with Rogers about the government action and its effects, namely what Rogers calls the inflation holocaust that is to come. Highly recommended for Common Sense Investors.

A famous quote from Jim Rogers:
“If you were smart in 1807 you moved to London, if you were smart in 1907 you moved to New York City, and if you are smart in 2007 you move to Asia.”

Rogers, following his own advice, moved to Singapore in September of 2007.

Jim Rogers is saying what Peter Schiff and what countless other financial experts and economists have been saying as well: “Don’t interfere with the market”. And he’s coming up against the same backlash that they’ve all come up against. Media pundits don’t like to hear about the “hands-off” approach, they’re inherently motivated to do something, even though that’s exactly what causes the problems. Those media pundits have an extreme anti-market bias, which is the natural default way of thinking for most people.

It seems like no matter how bad things get because of government interference and no matter how obvious it becomes, people refuse to accept free market explanations. Michael Shermer wrote about and explained that anti-market bias in his fantastic book The Mind of the Market; which is a topic for another time.

The US automotive industry has been soundly beaten by foreign competition over the years. That’s why the industry as a whole begged Congress for the $25 billion in low-interest loans. They said they needed it to better compete with foreign automakers. But pumping taxpayer money into private companies isn’t going to help them compete, the problem lies in 1) Poor management, and 2)Bad legislation. We can’t do much about #1, but we can fight to change #2, but we need to understand it first.

Here is a great video interview with George Reisman about minimum wage laws and unions and their effect on the quality of production and the economy as a whole. Bear with me, the video may start off a bit slow for those who aren’t interested in economics, but gets interesting as Reisman talks about the real effects of unions on US automakers. Highly recommended for Common Sense Investors.

I’m of the opinion that the government never gets anything right, well they proved me wrong today.
The Paulson bailout bill needed 218 votes for passage, but luckily it came up 13 votes short: the final vote was 205 to 228 against. Two thirds of Democrats and one third of Republicans voted for the measure.

This $700 billion financial bailout plan would have been worse than the problem it’s trying to fix. As Peter Schiff repeatedly says, we have got to let this problem run it’s course, we cannot keep prolonging the badness.

The markets reacted violently, of course. The Dow Jones industrial average is down almost 800 points – nearly 8% off the close Friday. The 777-point decline for the day surpassed the 684-point drop on the first trading day after the Sept. 11, 2001, terror attacks. But Common Sense investors should view this as fantastic news, news that our government isn’t as inept as previously thought.

What to do now?

Right now, I’d reiterate my previous advice, and the advice of Peter Schiff: “Get out of Dodge”. As an investor, you should keep your holdings away from the US dollar. Invest in things like gold, European stocks, Singapore currency and stocks, other Asian stocks; that’s the only way you’re going to be able to preserve your wealth as the dollar continues to decline, which it will. If you’re not willing to completely avoid US stocks, then at the very least diversify your portfolio with more gold and more non-dollar based securities.

Schiff said, in a recent US News and World Report article:
“There will be a big increase in crime. People are going to be hungry. People are going to be cold. There’s a sense of entitlement in this country, and when a lot of people used to having things suddenly don’t, everybody looks for someone to blame. We’re going through a very rough period in our history.”

Arthur Laffer makes a 1 cent bet with Peter Schiff back in 2006. Schiff, of course, won.

Check out a whole slew of Peter Schiff videos, with tons of valuable information:

Peter Schiff talking on Bloomberg about the Moral Hazard and monetary policy.

Peter Schiff talking about the true definition of inflation on my favorite show, Squawk Box, back in 2006.

Here is the economic debate that the people should have heard, not McCain vs Obama, it’s Peter Schiff vs Stephen Leeb.

Schiff talking about where to be when the deep badness comes: Gold, euro stocks, etc…stay away from the dollar.

Peter Schiff talking about a possible mega-panic worse than 1987.

Schiff talking about Ben Bernanke willfully lying to the American public, and the failure of the current interventionist policy.

One of the best videos, Peter Schiff laying out exactly what the problem is and what the solution is. Well done.

Every time Peter Schiff appears on TV, other pundits always seem to get upset, and it invariably turns into a screaming match, but he’s always right. Time has always proven him correct, consistently on almost every call he’s made. Learn from it, realize it’s happening, and most of all, take his advice, buy gold and Euro stocks and foreign currency. His track record speaks for itself, it’s just Common Sense.

Today, Knowledge Learning Corp, a privately held education provider, said it offered to buy Nobel Learning Communities Inc (NLCI) for $17 a share, which is a 33% premium over NLCIs closing price on the 20th. That caused stocks to soar 25% today to match the offer.

Of course Knowledge Learning offered $17 a share, NLCI is worth that AND more. Nobel Learning Communities, Inc. (NLCI) is a small, 167 million dollar company with a whopping 25% insider ownership. If you’ve been reading Common Sense Investor, you know how much we love insider ownership. This is a tremendous company that has built up a great school system spanning over 16 states. It’s consistently rated highly by teachers, parents, and students. It’s just a solid company.

The unfortunate fact is, they were “under the radar” up until today. After today, people will know that Knowledge Learning wants to buy them, and they’ll start doing research into NLCI. They’ll find the quality, and the stock price will rise. Not really so unfortunate, it’s just a shame you missed out on the one day 25% jump.

As for why they’re so great: The sector is strong, and strong companies in the sector will do doubly well. Every study that’s been done looking into the issue has found that average cost per pupil for public schools is twice that of private schools. Compound that with the fact that private schools do a much better job educating students, and you get the picture. Private schools do a better job for less money. Why do public schools still exist? Ah yes, the government.

Either way, more and more parents are realizing this fact and moving their children to private schools. Even politicians are realizing it and starting contract out programs and even whole school systems to private companies. This is a very good thing for everyone, except maybe bad teachers. This will mean only good things for Nobel Learning since they provide services highly compatible with public schools. They aren’t the haughty-taughty private schools you see in film, with uniforms and Latin classes and mahogany walls. They’re just well-run schools for regular kids. They do a good job, and they’re inexpensive. That’s all there is to it.

Check out this interesting video, not about Nobel Learning specifically, but about the public/private problem:

The government has “temporarily” banned the trading practice of betting against financial stocks, but only on some stocks. The reason is supposedly to try to boost investor confidence.

Now, there are a few questions to come to mind: What is Naked Short Selling?, Why is everyone saying its so terrible?, and Is it really as bad as they say?

Now, firstly:

What is Naked Short Selling?

Let’s go over what regular short selling is. Selling a stock short is taking a negative position on a stock, it’s essentially a bet that the stock price will go down. To do this, a person has to first borrow shares from a brokerage house or a bank, sell those, and then buy shares of the stock back at a later date to repay the borrow, hopefully when the price has gone down. It’s common practice on Wall Street, and is really just a form of credit given by the brokerage house or bank.

Naked short selling is selling a stock short without first borrowing the shares. If a stock is illiquid (no shares readily available), and a trader wishes to speculate on an anticipated hourly move in the share price, nothing is harmed by allowing him to sell 1,000 shares and then buy them back 45 minutes later. That, too, is common practice on Wall Street. Naked short selling helps the market prices adjust quickly.

Why Is Everyone Saying It’s So Terrible

This really is a deep question that has more to do with human psychology than it does with the market. Some bad things are happening in the market right now. When bad things happen, there needs to be an explanation, there needs to be someone to blame.

Finding someone to blame, whether it’s right or wrong, gives the person doing the blaming power; political and financial power. It makes it appear that they understand the situation and have it under control.

And really, short sellers are easy to blame. They’re betting the market will go down. We naturally hate those negative bastards right? They shouldn’t be hoping the market will go down (even though that’s not what they’re doing, they’re only trying to make money based on what they think will happen, just like anyone else in the market). There’s actually a Latin term for it: Cui Bono. It essentially means, “when something bad happens, see who benefits from it, and blame him”. But short sellers are not to blame for the financial crisis any more than long sellers are to blame for the success of a company like Apple or Google.

Is It Really As Bad As They Say?

No, it isn’t.
People are concerned with price manipulation. The fear is that a rogue trader could spread false rumors about a company while massively shorting its stock. Such aggressive actions would supposedly push the price down, and allow the trader to make loads of money from his devious plan.

The fact is, though, that sort of thing doesn’t happen, and can’t. For one thing, why couldn’t large stakeholders do the same thing with long positions? Steve Jobs could spread rumors about Apple and begin unloading his huge position. After the price fell 50 percent, he could buy back his original position, having netted perhaps hundreds of millions of dollars in the process, and owning the same number of shares as before. Steve Job’s actions wouldn’t have changed the underlying profitability of Apple, and so its artificially depressed share price would presumably recover over time. No government regulations on short selling could stop this type of maneuver.

The market isn’t stupid. It takes manipulative schemes into account. For example, if the stock price of a well run company is going down because of a devious person shorting massive amounts, then informed investors will buy it up, since it’s then trading at a discount. This would offset the effect of the shorting.

The main point is that no one forces investors to listen to rumors, and good investors never will. Government regulations can’t protect people from their own gullibility. In fact, attempts to do so perversely give them a false sense of security, and make things much worse.

Conclusion

Really, the ban on short sales is pointless. All it does is prohibit naked short sales on nineteen “important” financial companies. In other words, even if a trader intends to short shares in one of the companies and to buy them back within an hour, the brokerage must first locate and borrow the shares before allowing the sale. The restriction apparently does nothing except require more paperwork and reduce the attractiveness of short selling. (Because of the extra delay, share prices might move before traders can short sell them.)

Short selling is a beneficial process that allows anyone to participate in the market’s price setting. So long as contracts are enforced, even naked short selling is helpful, since it allows the quickest possible adjustment in mispriced stocks. The government’s recent efforts to “protect” nineteen favored firms from naked shorting will do nothing but raise transaction costs.

Remember this: Banning short-selling is the financial market equivalent of making it illegal to argue on one side of a debate. It promotes a disconnect between price and value, which is what got us into this mess in the first place.