The Market Ticker

Ben Bernanke apparently, in his ivory tower madness, never studied physics.

Or anything related to the real world.

His famous 2002 Speech before the National Economics Club in Washington DC in which he basically said that deflation was "impossible" in a fiat money system because The Fed had a "printing press" which it could use to force people to spend (and prices to rise) irrespective of the natural economic forces at play is now proving to be his undoing.

There is a problem with this position - in true "Ivory Tower" fashion Ben Bernanke has forgotten that actions have consequences. See, Mr. Ivory Tower apparently never heard of one Sir Isaac Newton - "For every action there is an equal and opposite reaction."

The unfortunate reality - and one that Ben would have done well to recognize back in April, is that equities were vastly overvalued. All of this was a part of the same piece; we had "Merger Monday" every week, LBO money was flowing like water, and CNBC was constantly referring to the "sea of liquidity" that was flowing through all markets.

Unfortunately a huge part of this "water" flooded into the residential real estate marketplace. Helped along by "fog the mirror" loans the market rocketed higher.

What Ben failed to realize (because he was hiding in his Ivory Tower for most of his life) is that while he talks of "inflation expectations being anchored" the unintended consequence of "free money" is that consumer wealth expectations became anchored to 20% house price appreciation as well.

Consumers acted on this expectation and literally unhinged themselves. Not everyone, of course, but far too many people spent on their credit cards, then paid it off by shifting the debt to their "home equity", which had been pumped up by this "sea of liquidity."

The sad part of this is that for the last eight years Americans' median incomes have actually been declining in constant dollars, meaning that for the average American their purchasing power has been going down when measured by their earnings power.

But consumption hasn't been going down - it has been increasing at rates that, until recently, have outstripped price inflation.

How is this possible over the long term?

It isn't, of course.

For every action there is an equal and opposite reaction.

Mr. Ivory Tower never spent so much as 30 seconds in a physics classroom when he was playing Professor and achieving his "Piled Higher and Deeper" (PhD).

I've seen this too many times in my professional life, and in fact have participated in the act of getting multiple PhDs fired in my years in commerce. There seems to be a high correlation between extreme levels of "education" and equally-extreme levels of arrogance and lack of common sense.

In point of fact Ben cannot stop this deflation in asset prices. He can try to "hyperinflate" but in doing so he doesn't help anyone with anything (including himself and The Fed), because what matters in the end is purchasing power not the absolute levels of stock markets, and Ben's reach does not extend beyond The United States.

Sir Isaac Newton wins - there is a reason that in physics we call these things "laws", not "theories" or "suggestions."

In the last three days Ben Bernanke's Fed has put forward two separate "stick saves" as the markets have hovered over key technical levels, threatening to head for the Abyss for a close encounter with Lucifer.

First on Friday and then again on Tuesday, The Fed has come in with "emergency" actions announced just before the market open, spiking the futures in a vain attempt to prevent the breach of key technical levels that have threatened to set off a waterfall of selling pressure.

Ben of course, along with his economists, reads the same charts I and every other market observer read. We all get the same Wall Street Journal. We all see the Dow and S&P sitting on key levels of support, the 200 Week Moving Average and the threat of completing "Head and Shoulders" patterns that, at completion, point to much, much lower price levels - 20% declines from here.

We all see the Nikkei down 400, 500, 1000 points. We all see the futures lock-limit down over the MLK holiday.

And we all know that should the market open under those circumstances, a crescendo of selling will immediately ensue, washing out the market and dropping prices precipitously.

This, of course, is seen as "bad", because Americans have significant wealth in 401k and IRA plans. Adding to the "bad" is the fact that our government has steadfastly refused to admit the truth going back over a decade in regards to the financial markets and economy - market crooners on CNBC, Hanky Paulson and Bush have steadfastly maintained that "our economy is strong", urging people to "buy for the long term."

Unfortunately this is a lie, and Ben knows it.

What's worse, selling crescendos - huge washouts on huge volume - are what bottoms are made out of! True bottoms. Bottoms that hold.

But rather than do the right thing and come right out to tell the truth - you cannot build a sound economy by continually increasing leverage and spending the proceeds of gearing up, you must build it via production of goods and services, Ben has fiddled for years, refusing to both speak and act to reign in the over deployment of leverage.

See, reigning in that leverage means telling his "prime dealer" clients to cut it out. To come clean with their exposure and tell the truth. To be honest both with the American People and with each other. To tell their hedge fund clients that they will not permit gearing to be the foundation of their enterprises, and to eschew gearing as their own foundations.

Doing this would lead to precipitous declines in earnings among the S&P 500 financial sector - perhaps declines of 30, 40, 50 or even 75%. It would lead to precipitous declines in these firms' stock prices. It would lead to major declines in the stock price of those enterprises that have been "pumped" by that same leverage - Amazon selling at 100x earnings, for example.

Instead of allowing equities to correct in August and holding the line on liquidity, Ben decided to try to flood the system. This is not, as many have suggested, "inflationary" - the inflation happened from 2001 to 2007 through all the "liar loans" in both the commercial and consumer spaces, and now deflation of asset prices and the base against which credit can be issued is and will continue to happen.

You can't solve a drinking problem by pulling out another bottle of booze but you can die of alcohol poisoning!

What Ben has done is add tremendous dynamic instability to the system.

Earnings estimates for companies have also been based on the fiction that "fog a mirror" loans would remain available to both consumers and commercial enterprises, which has then translated into multiples that are, quite simply, unrealistic. Corporations have pumped their "earnings per share" without increasing actual earnings by engaging in stock buybacks financed with debt - yet another example of the artifice of "cheap credit."

In August we should have corrected down to roughly the 1220 level in the SPX, rattled around there for a while, and settled near 1070 this spring and summer. From there we could have built a base. Allowing the market to adjust gearing ratios last year would have resulted in lots of pain but in the end we would have taken that pain and be through the worst of it by now, when the recession was fully evident. We would have a much cleaner "balance sheet" upon which to build the next advance. Forcing lenders to mark houses down to realistic (3x incomes) values would have squicked huge numbers of people, but then it would be over.

Instead, what Ben has done is push on the pendulum to try to keep both the economy and equities higher.

Anyone who believes that you can do this without creating dynamic instability in the markets - snapbacks if you will - is a fool.

The 400 point rally that came Tuesday now appears to be a fool's errand and those who bought into it are headed for real trouble. Yesterday and today we had violent whipsaws in both directions but this evening we closed out lower than we were Tuesday night.

The unintended consequence of the Fed's fiddling is that now prime brokers have an incentive to seize the collateral of their hedge fund clients and forcibly liquidate them via margin calls, as they can now take that collateral to The Fed and swap it for liquidity, where prior to this action they would have had to sell it directly into an illiquid market!

In fact there is an argument to be made that the Carlyle collapse, which now appears to be "in process", was made a "fait accompli" by The Fed's most recent action!

This is likely to repeat among virtually any other fund or firm that is dependant on prime brokers for funding yet holds either agency or private-label mortgage securities as its "base capital", should they be employing leverage that is at any time deemed "imprudent" by those same prime brokers.

If you're a hedge fund, you're screwed. Of course Hedge Funds are major owners (and shorters!) of stocks, and when they are forcibly unwound, what tends to happen to prices? You add yet more instability!

What were people doing today as the market turned? Buying QID and SDS! Inverse 2x levered funds. Gee, you think that "buying" today might have been short-covering occasioned by hedge fund margin calls? I wonder....

Ben Bernanke is actually going to CAUSE the very stock market crash he fears!

One has to ask - has Ben finally found religion, if in an oblique way, or is he old-fashioned insane?

Does he actually want to provoke the deleveraging that he has, over time, apparently tried to avoid, and damn the instability that it causes?

Does he, perhaps, finally realize that he can't stop the deflation in asset prices, and that it is more important to save both himself and the prime brokers than those consumers and businesses that went too far?

If so we are headed for "natural" levels in the equity markets in short order, and it will be a true roller-coaster ride getting there.

Buckle up!

Speaking of where the problem lies, what sort of gearing does our "regulated" banking system have? 7, 8:1?

How about the "unregulated" folks, such as the targets of those 23A exemption letters and the hedge funds? Carlyle at 32:1?

Gee, how about you take the "UN" off "unregulated" YOU GOOFBALL! There you might find a solution to the problem!

I think Ben Bernnake may have discovered Sir Isaac, and if so, its just in the nick of time.

BTW, Paulson's press conference today, calling for more transparency, sounds good. The key is going to be whether he can actually get any of this done, and so far I have yet to see him say that we need to REGULATE those "unregulated" pools of funds, yet without those "unregulated" fools we would not be in this mess!

Color me skeptical.