We were right on the money yesterday here at Matt-That.com, with our prediction about the US stock market. As we expected, after washing out a false rally, the market turned downward. Howsoever, the sellers came out, presenting the kind of volume, that suggests we’re only closer to the second part of my prediction: that the market goes unfeelingly sideways.

In today’s session, traders and investors alike, from all around the world, will be forced to learn about a new mechanic taking shape in this market: Conjuration, I call it. Its certainly existed before, but not nearly as it does today.  Conjuration is the first step in creating pump and dump bear traps.

How do you create a Bear trap?  First, you conjure value out of thin air by suggesting if you miss a particular buying opportunity, you will get no other. This conjuration of value creates the same panic used during selling to initiate worry about being left out of the market, causing panic buying.

Today, we will conjure such value, in the form of a rally of immense proportions, with almost no basis in reality. This will form the upside dressing of the next stairstep down, continuing the wash-out of millions of new investors/positions. Soon, this exact ebb and flow will drive the market sideways.  The disinterest will be more profound when there is no dumb money to dump your shares on, nor trade volume to pump them up.

Many people have been taking advantage of the traders nature of this market — full of ups and downs. So, in order to remain safe, how can we time the beginning of this rather troubling event, of a side-ways market, to avoid holding positions on either side?

Monitoring the pessimism, using its reversals, we see its strength has grown to the downside, not diminished. So, we can begin to sell our short positions here (the most leveraged first). And we should not look to acquire many more leveraged positions going forward.  Leverage on any direction is the most dangerous position to be in, in a sideways market.  Logically though, what indicates the coming sideways market?

We’ve had sellers from 14,000 to now 7900.  And sellers came back into this market to take us to those levels. There can be only so much more selling pressure on the sidelines as we go.   But, what about the positive story then?  If we’re out of sellers we must be full of buyers, no? First rally almost 1000 points.  Second rally half, at just 550 points. Third rally, half again, some 250 points.  Strange, we’re running out of buyers too.  And that, is how you end up with a sideways market.

At points of maximum pessimism and optimism there must be cyclical reversals, otherwise a market has no psychological basis with which to use as function for pricing.  Todays cycle suggest the kind of rip-your-face-off rally we saw the first time.  And, like the first time, it will not hold.

The Dow Jones Industrial Average closed yesterday with a 7900 handle, 7997.28 to be exact. It marks the first time these levels were closing levels for the index in over 5 years (almost a full 50% down from the peak of a 14,000 handle just recently set a year ago, in October 2007).

Chart technicians are on both sides about what all this means.

I think its important to point out price action on another closely watched index full of widely held stocks, the Dow Jones Transports Index, which made a fresh low during this sell off. This is suggestive that today we will likely see that same action more broadly. Transports led us through the commodities moves on both sides, which have been nearly dead-locked with the market, in a state of stair-stepping deflation.  Trading volume has also wound down dramatically.

These are not indications of re-valuation of the market, nor are these indications of price re-entrenchment.  These are not indications of capitulation.  These are indications that the US equity market is about to change its tone dramatically.

The final destination of this market, after its traded down, washing out perhaps hundreds of thousands of new investors in hundreds of varied positions, is not excitement.  It is not a psychology of buy & hold. And it is most certainly not a market psychology which leads to rebounds. This market will trade into such low volume, continually taking out players, vaporizing capital turned equity, only further removing opportunities for uptrend trading.

In the end, the action will go side ways as the whole market becomes apathetic. And while all historical indication tells us that we have a green light in a Bull market, a red light in a Bear market, a sideways market has only one indicator and it hangs brightly now over the door: the exit light.

In February of 2000 Hank Paulson, then CEO of Goldman Sachs, testified to the Senate Banking committee requesting that they reduce restrictions on the financial services industry, allowing investment banks like Goldman Sachs, Morgan Stanley, Merill Lynch, Bear Stearns, and Lehman Brothers, to leverage themselves upward of 20 to 1 — to risk more than 20 times what they could bare to lose.

The request went denied then in 2000 by a regulating body still containing many members appointed by Clinton but was approved only four years later by the regulating body installed with the Bush administration.

Now, Secretary of Treasury Hank Paulson, a Bush appointee himself, asks the American people to pay for the results of those misguided and destructive business decisions and the ineptitude of officials, who realized too late the danger approval posed.

America confused, bewildered and driven by fear, agrees begrudingly to a 700 billion dollar bailout plan for financial institutions — the death of Socrates all over again.

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If I told you these circumstances were all that were neccessary to undo the great promise of America, you would likely have doubts. You, stubborn and loving of America, would with all that you were say “No. America is greater than that.” But my friends, there can be no doubt now, that we have traded all we once were away — we have become all we had ever hoped to avoid: Rooted in corruption; heartless and descrimitive; deluded beyond perhaps all sense of hope for a future.

We have given the Doctor Frankenstein’s of this particular American monster absolution.  Whats more we have placed them back in control of the laboratory to further ruin the great experiment that is the American dream.

They that can give up essential liberty to obtain a little temporary safety deserve neither liberty nor safety; Benjamin Franklin saw the soul of America and understood its fragility — our most recent actions will serve to prove him right. It is not what we have bought with these banks full of debt, but instead what we have had to sell of ourselves first in order to ever take ownership.

The S&P 500 fell below 1000 today. The DOW below 9500.  Some call for a DOW in the 8000 range, others as low as the 7000 range over the next year. Jeff Mackey from CNBC put it rather well the other day from his chair on CNBC’s Fast Money, when he talked about his two best positions for this market. The positions were cash & fetal.

Its shaping up to be another memorable October for people working in, or who report on, the Financial sector. The last 12 months have shown that anything is possible in financial markets. Credit spreads have widened to never before seen levels. Any short-term lending mechanics, but especially Commercial Paper, are frozen stiff. “Easy Money” is anything but.

This time just last year — on October 5th, 2007, the Dow Jones Industrial Average closed at a price of 14,066.01 on a volume of 29,190,300. To put things into perspective, today — October 3rd, 2008 — the Dow Jones Industrial Average opened at 10,483.96 on 264,270,000 average volume.

The next 12 months prove to be interesting for those who find themselves in the boundaries of what remains of Wall St.  The coming earnings seasons will expose with certainty, the fact that we are (and have been) in a recession. Between dwindling credit, falling consumer confidence and spending, and growing unemployment statistics, there are few reasons to expect that companies will turn anything like the profits to which Wall St. is accustomed. In fact, it will be intriguing to see what innovation and consolidation take place in order that many major players are able to survive.

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The credit markets have pretty much frozen as banks are unwilling to lend to consumers or each other in a deafening reduction of confidence.

Many banks made mortgage loans with impossible terms or to unqualified borrowers. These banks then invested in securities backed by these now failing loans. It is this hidden potential for toxic holdings that reduces bank-to-bank confidence. And even a banks own self-confidence in consumer lending, if the bank itself relies on borrowing.

The reaction from the US government to this problem has been to provide liquidity to reinflate confidence. This has been unsuccessful, largely because, its dependent upon setting a floor on the US mortgage market and/or mortgage-backed securities market despite a natural state of correction in both. Price-fixing will not help lending between banks nor free-markets. Since inter-bank lending is immediately crucial to the economy, I present my own idea for solving this problem with our banking system.

Two important points; first, lending is both in the near-term costly and risky. Second, the current rash of government backstop-lending is no different with few exceptions (since the government controls the rules of the market).  This is the more important power of the government, not its ‘infinite’ supply funds, but its ability to control the rules. 

What if the Federal Reserve in coordination with the FDIC opens a new window.  This window will help banks lend to each other without lending them a thing. For a smartly set (perhaps percentage based) premium to the bank borrowing, the US government would — like a bank certifying a check — hold in escrow the amount of some bank-to-bank loan. Then, on at least these occasions, US banks could ensure transactions with each other through the help of their shared regulators and assistance providers.  Obviously, when and where these banks felt more comfortable, they could go back to working together directly.  The impact of the premium is disincentive to using the window.

This would be self-sustaining through premium collection and would not be harmful to the banking system or US tax-payer. I believe something as simple as this could help form an insurance for slowly winding down the operations of other windows at the Federal Reserve.  The windows could then help to support each other until varying crisis are resolved.

So its about time we reintroduce an old friend. I brought him — the idea — out a bit early. And then put him away because the idea is alarmist. Its an idea I’ve hated to have fostered at all quite frankly, but its one that is hard to deny given whats transpired.  Super-bust.  I’ve written about it before in June with Back to The Future. And back in March with Four Magic Words and Four More Magic Words: Where is my Money.

I never could have imagined things would happen as quickly as they did, certainly not using the information in front of me — isn’t that what they all say though? The talk now in Washington is, if we don’t accept Paulson’s $700B billion to $1.2 trillion bail-out plan and fast, we’ll not be able to avert serious systemic damage.

The fact is, we’ve already experienced and some of us truly suffered, serious systemic damage.  For instance, here’s a new piece of trivia for you to shop around the office: When was the last time the US had no major Investment banks? Or, what did the US credit market look like then? We care because, as of today, there are only specialty houses and the boutique investment bankers left.  Bear Stearns exploded back in March — it took JP Morgan Chase and $30B of Fed loans to put out the flames. Merill Lynch got bought by (shudder) Bank of America.  Both Goldman Sachs and Morgan Stanley were run off of Wall St. and toward the lender of last resort, the Fed, having converted to commercial banks.  And Lehman Brothers is odd man out with the Fed for whatever reason and goes essentially bankrupt.

Paulson’s plan will do nothing to bring back the vast financial innovation, command of respect, and pure flow of capital these companies brought to the face and body of the US economy. They are causalities of a lack of oversight in a system where you’re insolvent by association. Thats exactly why Paulson wants Congress to give him a permnant supply of rockets for his bazooka. But is that what America really needs: our tax dollars with Hank Paulson, running the World’s Biggest Hedgefund?

George Bush may well be the most thoughtless President in American history. Under his Administration, all of America has fallen apart. It is without any sort of reflection that he may well also put an end to this idea of American history, et al. At the G8 Summit, our President, the “leader of the free world”, whose known for sharp wit, powerful wielding of the English language, and infinite charm and savvy, went ahead and showed exactly how concerned he is about the environment; he joked about it. So, to all my friends out there who voted for Mr. Bush: thanks.

I want to tip my hat to you (in that now almost Daily-Show-famous, ‘drunken-presidential’ way) and say with all the sarcasm in my black little heart “Ahahahaha, Yes! Lets Wreck the Planet… So We Along With All Other Life Can Die A Horrifyingly Slow, Painful, Human-Engineered Death… Wheeee!!!!” Now, isn’t that something wonderful to laugh about?

Bush thought so; Goodbye, from the world’s biggest polluter!