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!

Huxley, Friedman and Roosevelt

Perhaps the deepest truth I know of, is an utterance that comes to us long lost from an English novelist of the 19th Century by the name of Aldous Huxley, who said “That men do not learn very much from the lessons of history is the most important of all the lessons that History has to teach.” Today we live in a literal proof of a society misunderstanding of the profound nature of this observation, at least economically speaking. In 1929, on the day the stock market crashed, the headline of Variety read, Wall Street Lays an Egg. Thats timid compared to whats already been said about today’s circumstances. The fact is though, Variety like today’s media, has it all wrong.

It was the economist Milton Friedman who best summed up the cause of our present-day economic woes with his thoughts on what caused the Great Depression, saying “The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy,” Change came from an usher as desperate as were the times. Just four short years later, in his 1933 campaign speech, Roosevelt said, “It is common sense to take a method and try it. If it fails, admit it frankly and try another. But above all, try something.” And try they did.

Day in the Life

Such brute force as proposed there, howsoever, will serve ill the very different America of today. How different is it? In some ways very different, in others respects not at all.

- Food Shortages: The Tri-State Observer reports that the US has no remaining grain reserves…

According to the May 1, 2008 CCC inventory report there are only 24.1 million bushels of wheat in inventory, so after this sale there will be only 2.7 million bushels of wheat left the entire CCC inventory,” warned Matlack. “Our concern is not that we are using the remainder of our strategic grain reserves for humanitarian relief. AAM fully supports the action and all humanitarian food relief. Our concern is that the U.S. has nothing else in our emergency food pantry. There is no cheese, no butter, no dry milk powder, no grains or anything else left in reserve. The o°©nly thing left in the entire CCC inventory will be 2.7 million bushels of wheat which is about enough wheat to make 1?2 of a loaf of bread for each of the 300 million people in America.”

Here is a direct link to that report.

- Energy Crisis: Fox News asks, “Are We at Risk of a Global Recession Because of Oil?”

- Environmental and Natural Disasters: Some of these Oil spills, Ozone depletion, Earthquake related Tsunamis, a European heatwave that killed over 37,000 in 2003, and Hurricane Katrina just to name a few.

It sounds as if I’m describing doomsday but I’m not. I’m describing today, the 1930s, the 1970s, and I might as well be describing any day at random. The fact is these things happened before and will again. And Huxley’s lesson will continue to escape most of us just as it has done and will continue to do.

Not everyone comes as late to History class fortunately, some realize this and try and find new, more useful ways to look at the past. And some manage to apply what they learn. Current Macroeconomic theory suggests consumers and businesses of Great Depression era relied on cheap credit. Consumers did so purchasing goods, while businesses did so investing in production. This economic behavior fueled rapid, short-term economic growth, creating swells of debt. When prices deflated, growth essentially collapsed. As the corporations and consumers both defaulted on loans, unclaimed, full inventories further deflated prices. The corporations laid off workers reducing consumer spending, eventually creating a kind of self-sustaining cycle, and later the wave of defaults shook banks. Confidence plummeted in corporations, the markets, and finally the banks themselves, creating a ‘run on the bank.’ This suggests a way to look at today.

Today, we face very alike conditions. A systemic networked banking system creates investment banks such as Bear Stearns, called “too big to fail”, that require 30 billion dollar rescues when the same debt-fueled growth cycle causes just their collapse. And while that may have plugged one very apparent hole, the overall cycle will continue.

Starting in 2003 until sometime in 2007, the economy saw the same sort of rapid, short-term growth across a majority of markets, favoring housing, equities and derivatives, relying on the same kind of cheap, plentiful credit used prior to the Great Depression. Today different from the 1930s, that cheap credit has been delivered by sharing the debt amongst banks and further wrapped up as derivatives securities — this, and inter-bank lending creates the systemic connection between banks potentially making them too big to fail.

Before long though, debt-fueled growth causes confidence scares; loans come to term and defaults drive the flow of money out of lenders and spenders and into things like commodities, where the cycle enters the next phase. The new and higher commodity prices push down the equities and other securities and raise costs. The whole tree begins to poison, spreading one branch at a time.

Back to the Future

The future cannot be known but the past is not as limited. Thus, I feel confident in the future I see ahead, so mindful of the past. I say next, we’ll begin to hear about other lenders, spenders and connected investment vehicles; as CNN has only just put it, there are more perils ahead. Problems will crop up with automobile loans and students loans as well the securities that are related. The government may step in or reduced auto sales might help ease certain energy prices; the oil bubble might burst, leaving just food and other inflation to deal with. The student loan market is already drying up though and the government is already getting involved.

Despite the panic in the markets and all the volatility, I’m confident, though I realize quite sadly, to know our future, we needn’t look into any sort of crystal ball, but instead right where Huxley would suggest, using eyes focused backward in time.