All the ingredients for another major downside move (below 700) in the S&P 500 are now in place. A slew of economic data over the holidays proves that the emerging markets have finally entered a decisive contraction phase, which means significantly lower asset valuations and collapsing consumer demand throughout the developing world. And, as far as the domestic environment is concerned, rather than focusing on systemic risks, the Fed and the Treasury have embarked on a series of monetary policy and bailout decisions which are almost entirely predicated on the hope that the US economy will take a turn for the better in late 2009 or early 2010.

The case for short equity positions (ADRE, DIA, EEM, QQQQ, SPY, XLF) could not be stronger and is, in fact, fortified by the fact that the very concept of systemic risk is either horribly misunderstood or simply ignored. One component of systemic risk is public confidence that failing banks will not wipe out family savings. The other is the guarantee that essential day-to-day business (exchange of food and essential commodities) can be conducted under logical assessments of counterparty risk, as opposed to a virtual standstill in the credit markets. The third, and perhaps most important, component of systemic risk is the ratio of productive and non-productive (e.g. financially engineered products) assets within a particular economic matrix.

Drawing from studies of the Great Depression, policy-makers like Ben Bernanke are convinced that if the apparently vital constituents of the economy (AIG, C, GE, GM, GS and now GMAC) are kept alive long enough, a sustained uptrend in asset valuations, household wealth and home prices at some point in the future will return those constituents to health and prosperity. The difference between the 1929-1933 period and today, however, is stark. Shortly after the First World War, debt was mainly being incurred by industry to finance expansion. Over the previous two decades, a huge proportion of total outstanding debt has been incurred to promote financial activity bearing no relationship whatsoever to identifiable industrial or agricultural growth.

In 1982, financial institutions accounted for 5% of total corporate profits; that number rose to 41% by 2007. In 1995, the face value of asset-backed securities stood at $108 billion; within the following decade, that number had risen to $1.24 trillion. The notional value of bond default-related insurance products, which were hardly known in the early 1990s, reached $250 trillion-plus by the first quarter of this year. The Bank for International Settlements estimated that the underlying amount of over-the-counter derivatives exceeded $685 trillion as of the end of June. The daily turnover in the foreign exchange market was almost $2 trillion prior to the start of the credit crunch.

Quite clearly, policy-makers needed to distinguish between the systemic mechanisms which threatened the viability of the domestic economy, and the global economy in certain instances, on one hand and the risks posed by the largely non-productive debt and derivatives bubble on the other. The critical systemic challenges of protecting savings and moving credit to the engines which drive an economy cannot be confused with bailouts, many of which have been undertaken for failed business models or for business models which are evolving with each passing day.

What the equity markets are now confronted with in forthcoming months is a real contraction in business activity, further erosions in asset values, a huge downsizing of balance sheets in the banking and finance sector, a conclusive decline (and adjustment) in corporate earnings in line with the new business reality and dwindling household wealth. A cyclical bottom-picking approach is without foundation. Investors need to position themselves accordingly.