A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Puteo

``In a previous speech I suggested that periods of great market instability arise when three conditions are met. First, something happens that has widespread significance—is large enough to matter to lots of people. Second, the triggering event is a surprise. Ordinarily, events long anticipated are not troublesome because corrective action occurs before problems arise. Third, substantial uncertainty clouds resolution of the problem. It is especially difficult for investors to know what to do when the government's response to an unfolding situation is highly uncertain.”- William Poole, President, Federal Reserve Bank of St. Louis, Housing in the Macroeconomy

There are those who argue that the FED will remain hawkish and unlikely apply the Bernanke “Put” in the face of the unfolding liquidity squeeze.

A put option gives a buyer the right to sell a security/contract at a fixed price within a given period. Puts are essentially a hedge from declining prices. The Greenspan Put assumes that investors will be rescued by then Chairman Greenspan in response to an unraveling crisis with a series of interest rate cuts and injections of liquidity.

Figure 5: Yardeni.com: FED Cuts in at almost every crisis!

Figure 5 courtesy of Yardeni.com tells us that each time the US economy or financial markets faced an ongoing crisis, the PUT option was activated.

I think that under worsening conditions, Mr. Bernanke will be compelled to apply the PUT given the following:

First, it has been the FED's "winning formula" since ex-Chairman Greenspan took over.

Second, this path reflects on Bernanke's ideological inclination as signified by his speech at Milton Friedman's 90th birthday and his Helicopter (November 21, 2002) speech.

Third, I think being hawkish is merely rhetorical. Considering the complexity of today's financial instruments, several FED personalities, including St. Louis Reserve President William Poole (who has been stridently hawkish) has in the past acknowledged the uncertainties emanating from GSEs and untested financial instruments and their potential impact to the markets and the economy under severe or "testing" conditions.

Lastly, given the magnitude of financial leverage in today’s economy, I don't think the hawks can afford to tolerate a squeeze in liquidity, which should bring about the risks of debt induced deflation, something which Mr. Bernanke fears most.

Former Fed Chief Paul Volker acted to quell inflation in the late 70s because it was visibly exploding then. However today, such scenario has yet to egregiously manifest itself. Think of Gold $2,000 or more. Nonetheless, the act of preemption could spur negative political repercussions in the light of upcoming elections.

As Nicolas Taleb wrote, "Everybody knows that you need more prevention than treatment, but few reward acts of prevention. We glorify those who left their names in history books at the expense of those contributors about whom our books are silent. We are not just a superficial race (this may be curable to some extent); we are a very unfair one."

Since an ounce of prevention will unlikely lead to manifest rewards, based on incentives as a driving factor to the Fed’s decision making process, then they would likely opt for a treatment based action instead similar to its actions in 2000, as shown in Figure 6.

Figure 6: Economagic: FED Cuts as Rate as S&P fell!

To be sure, a cut in FED rates poses no guarantee that it will instantaneously boost the equity markets. The FED initiated its monetary actions by paring interest rates (red line) in late 2000 when the S&P 500 (blue line) has declined by as much as 15%! Yet, the rate cut did not deter the S&P from losing about 45% (peak to trough) as Fed rates nearly reached the floor at 1% in late 2002.

In the same context, we believe that similar circumstances would prompt for the FED to its traditional action, i.e. if US markets gets creamed by the worsening of credit conditions. Losses of anywhere between 10-15% could likely be the trigger.

However, anywhere in between now and 10% decline is likely to be a normal corrective phase and would NOT prompt any FED action.

In the meantime, taking defensive measures to preserve capital would likely be the best recourse under the current deteriorating conditions.

This could be a bear trap though, but given the fundamental developments, it seems unlikely so. I hope again I am wrong with such bearish outlook.

Finally, the PSE has introduced a new trading mechanism called the shorting facilities. It allows investors to profit from declining prices by borrowing shares and selling short an issue then buying back at a profit once the target decline in prices are reached. Inversely, cutting loss by closing an open position once shares move up instead of down.

I am not sure if this has been activated, although it sure is one good time to give them a test, especially if the Phisix comes off from a dead cat’s bounce.