The New Road to Serfdom?

Stocks plunged for a second straight day Thursday, falling to levels not seen in at least five years, as financial and energy stocks tumbled while demand for the safety of government debt spiked:

Wall Street saw the most intense selling late in the session after hopes faded that lawmakers would quickly assemble an aid package for U.S. automakers, and as the Standard & Poor's 500 index broke through lows established in 2002. That breach of a key technical threshold sent a shudder through the market and touched off further selling.

The S&P 500 index fell 6.7 percent to its lowest close since April 1997. The Dow Jones industrial average, meanwhile, fell 445 points, or 5.6 percent, to its lowest close since March 2003. The decline brings the Dow's two-day drop to 873 points, or 10.6 percent, its worst two-day percentage loss since October 1987.

Financial stocks plunged on worries that the government's financial rescue won't be sufficient to cover banks' losses. Meanwhile, a sharp drop in oil prices weighed heavily on energy companies.

Thursday's pullback came amid heavy volume, a welcome sign for some investors who are looking for the market to experience a cathartic sell-off that could lay the groundwork for a recovery. Heavier volume can signal investors are scared enough to sell rather than simply sit on the sidelines, which can result in relatively light volume.

Observers said the selling highlighted the entrenched pessimism about the prospects for the economy.

"Unrelenting gloom has taken over the markets," said Dana Johnson, chief economist at Comerica Inc. "The economic news, the concerns about some major financial institutions, the concerns about the auto sector, earnings reports, everything is coming out in a way that is just provoking a massive selling in the stock market."

"Back in October we were looking at a potential catastrophic meltdown of the credit markets, and that didn't happen," he said. "But that doesn't mean tremendous damage hasn't been done to the economy."

Those worries about the economy sent the Dow down 444.99, or 5.56 percent, to 7,552.29. It was the biggest percentage drop for the blue chips since Oct. 22 and the Dow's lowest close since March 12, 2003.

Broader stock indicators also showed huge declines. The Standard & Poor's 500 index fell 54.14, or 6.71 percent, to 752.44, below the closing low of 776.76 logged on Oct. 9, 2002, to its lowest close since April 14, 1997.

The Nasdaq composite index fell 70.30, or 5.07 percent, to 1,316.12.

The Russell 2000 index of smaller companies fell 27.07, or 6.56 percent, to 385.31.

Declining issues outnumbered advancers by more than 10 to 1 on the New York Stock Exchange, where consolidated volume came to 8.96 billion shares, the heaviest level since the 11.20 billion seen on Oct. 10.

Jon Biele, head of capital markets at Cowen & Co., said investors are bracing for more bad news.

"The view on the floor is nobody is sure what the next stop is," he said. "I think the market is expecting another shoe to drop."

"Some people think this is the capitulation we've been waiting for," he said. "All along we've been hoping for a real violent sell-off and the end of the day today was a pretty dramatic move."

Bond prices showed stunning advances as investors clamored for the safety of government debt, sending Treasury yields to multiyear lows as fears about the auto industry make it hard for credit markets to function.

The yield on the benchmark 10-year Treasury note sank to 3.00 percent, the lowest point since 1958. The 30-year bond's yield fell to 3.46 percent -- the lowest since the government started issuing the bond in 1977. The yield on the 2-year note, meanwhile, fell to 0.97 percent -- the lowest since 1947, according to Global Financial Data in Los Angeles.

Stocks rose briefly during the session on hopes that Washington would agree to help Detroit's Big Three. But Democratic leaders in Congress delayed a vote on bailing out the auto industry until December and are asking General Motors, Ford and Chrsyler to present a plan to show how the $25 billion cash injection they have sought would be used.

Investors who have been groping for a bottom to the yearlong market rout have been worried that Washington's disagreements over whether to bail out the auto industry could lead to bankruptcies that would cascade into other industries and throw perhaps millions of workers out of work.

There are differing views on the bailout of the auto industry, but if you want to hear an excellent discussion, watch Charlie Rose's interview with David Cole and Andrew Ross Sorkin (click here to watch).

On the stock market, I think that today might have been the last severe shakeout for a while because volume on the Dow picked up significantly, but it was still below the October 10 spike in volume.

These markets are extremely fickle because they were built on a pile of toxic debt. Now that the global Ponzi scheme has lost its oxygen - cheap credit + leverage - it is deflating at light speed, sinking good and bad stocks.

The drubbing in equities keeps hurting more large pension funds. Today, we learned that losses in the stock market have knocked New Jersey's pension investment funds from $82 billion last June to less than $58 billion now, prompting one state senator to call for twin probes into how the funds lost so much money.

Moreover, the Massachusetts public pension fund lost about 13 percent of its value or about $5 billion last month, but still outperformed similar funds:

Massachusetts’ pension system fell by a staggering 13.3 percent last month alone, losing another $5 billion amid a Wall Street free fall that’s hammered investors across the nation.

So far this year, the pension system for state employees has lost about $13 billion, down 26.9 percent. It ended October at about $40 billion.

The state can take some solace in knowing that others are getting hit harder. The Standard & Poor’s 500 is down 33 percent for the year, while the average large pension fund has lost about 28 percent, according to a spokeswoman for Treasurer Tim Cahill, who serves as chairman of the state pension’s board of overseers.

Mike Travaglini, executive director of the pension, said the system’s U.S. and international equity portfolios got hit the hardest last month, with each category losing 19 percent in October.

The system was buffered by the relatively stronger performance of its hedge-fund and private-equity investments, which lost 1.6 percent and 5.5 percent, respectively.

But they were still losing money.

“There’s not one asset class that has positive returns this year,” said Travaglini.

While saying the markets are going through “very challenging times,” Travaglini expressed optimism that fund returns will reverse course again someday. The state’s pension system has averaged a 10.5 percent annual return since 1985, he said.

As far as hedge funds are concerned, the latest data show that hedge fund assets shriveled by 9 percent last month, sinking to their lowest level in two years as stocks tumbled and investors withdrew a record $40 billion.

Funds of hedge funds, which allocate money to a range of underlying managers, saw the most redemptions at $22 billion last month, HFR reported:

Such funds have lost 18.5% on average this year, while the average single-manager fund is down 16%, according to HFR indexes. That may be disappointing because funds of funds are supposed to be more diversified and less risky than single hedge funds.

The problems may be driven by more than disappointing performance, though. In October, investors withdrew almost $11 billion from global macro hedge funds, in spite of returns of more than 4% from those types of funds so far this year, HFR noted.

"Performance of the hedge-fund industry has declined over 17% since October 2007, making the current performance drawdown the largest in history," said Kenneth Heinz, president of Hedge Fund Research, in a statement. "The industry has now registered five consecutive months of losses, another inauspicious first.

"Consolidation is likely to continue into 2009 as investors across all asset classes indiscriminately liquidate assets to move portfolios into cash," he added.

Including fund performance, industry assets dropped $155 billion to $1.56 trillion in October. That follows a $210 billion decline during the third quarter, according to HFR.

And now some people fear that the volatile markets will spur hedge fund fraud:

Losses of roughly 15 percent this year and a growing sense of panic as hedge-fund clients exit worldwide are creating ripe conditions for a small number of the estimated 9,000 hedge-fund managers to break the law, according to forensic accountants, private investigators and former prosecutors.

"In volatile markets there is a greater likelihood that a manager might want to try and cover up his tracks by issuing bogus reports or making false valuations of securities if the market has turned against him," said Walter Pagano, a former Internal Revenue Service agent who now heads the Litigation Consulting & Forensic Accounting Services Group at Eisner LLP.

Whether managers fabricate returns to salvage ailing funds or spend clients' cash on fast cars or famous paintings for themselves, industry experts said fraud is often accompanied by warning signs.

"There usually isn't one big red flag," said Peter Turecek, a managing director at Kroll Inc, a risk consultancy owned by Marsh & McLennan Cos Inc , the world's largest insurance broker. "But often there is a pattern of little red flags."

These include returns that look too good to be true, accountants said. Investors should ask secretive hedge-fund managers to show more than top-line numbers and to provide details on how they make money.

Investors should also keep an eye out for sudden and unexplained expenses or news of big purchases of yachts or planes, the experts said, noting that the manager of a $2 million fund should not be flying around in a private jet.

My advice to any pension fund investing in hedge funds is to watch them like a hawk and if returns look too good to be true, do not be afraid to ask some tough questions.

But beyond hedge funds engaging in fraud, there are plenty of other shoes lurking:

John Osbon, founder of Osbon Capital Management, points to three instances in the past few decades that he believes functioned as other shoes prior to periods of healthy growth. The first was on Aug. 12, 1982, when Mexico defaulted on its debts. The second was in January 1991, during Operation Desert Storm, and the third was the March 20, 2003, invasion of Iraq.

Currently, Osbon thinks that there are plenty of shoes lurking. He sees a currency crisis as one likely source of massive pain, another being what he calls an "iconic" bankruptcy outside of the automotive industry. A third possibility would be trouble at a major pension fund like CalPers or TIAA-CREF, which should lead Osbon into interesting conversations with fellow Forbes.com Investor Team member P. Brett Hammond, chief investment strategist for TIAA-CREF.

Osbon said he could imagine benefits and payouts cut by 30% at these two companies due to investment losses. "That would be a real hit with real money," he says.

Already in Canada, some are asking whether pensions are safe and people are realizing that if pensions fail, taxpayers are on the hook for billions.

This is what I call the new road to serfdom. Taxpayers will be bailing out pension funds for years if a catastrophe strikes and they have a right to know a lot more about how these investments are being managed.

Finally, tonight I learned that Richard Guay, the president and CEO of the Caisse, is on leave until December 10th on his physician's advice.

I wish him a speedy recovery and I hope that those people who lost their jobs will find new ones soon.