I know I've said that before.

Let me expand on it a bit.

Everyone thinks of the Stock Market Crash of 1929 as having been caused by "irrational exuberance".

Nope.

The panic of '87 and the crash of 00/01 was thought of the same way. Nope.

So what causes them?

Overuse of leverage.

In other words, they start in the credit markets.

Always.

Irrational exuberance causes people to overuse leverage. It creates an environment where people become blind to risk; they start to think its all under control because nothing bad has happened for a very long time - there have been no (or very few) defaults, nobody has lost big money, etc. So they lever things up more and more. It is not the retail investor who does this - retail investors are limited to a 2:1 leverage ratio for stock purchases (although if you write options you can generate incredible leverage - and risk! Nonetheless, few retail investors write options while lots of people buy and sell stocks.) It is the corporate investor - the hedge fund, the corporation that is financing deals with paper instead of money, the money-center bank that is managing hundreds of billions in swaps and derivatives.

So why does it start? Pretty simple, really.

Think about a thousand sticks of dynamite. You place them 100' apart. Then you go to any random one and light the fuse on it. It explodes, but that's all.

Ok. Now do it again, but move them closer - 50' apart. Same result.

Keep going. Eventually, you reach a point where they are close enough together that the concussion wave from the first one sets the next one off! This continues until they have all detonated.

Think of the space between the sticks as the density of leverage. When it reaches a critical point, failure in one place sets off a cascade of failures through the system.

The problem is that nobody knows exactly how dense risk has to be packed before a chain reaction will sustain itself - until it does!

Where it gets particularly nasty is when people think risk is spread out but it really is not. This is particularly dangerous in the current environment because many of the credit derivatives are so complex that understanding all of the interconnected parts becomes nearly impossible.

Note that you do not need a crash to get a Bear Market. Japan had a very long Bear Market in the '90s without a crash in the Nikkei. It just went down, down, down. Some would say that 00/01 wasn't a "crash", but I'm not sure I'd agree with that - it wasn't an explosion, but I think most people would characterize it as, indeed, a "crash".

If we are going to experience that sort of event again, and I suspect we may soon, it will be due to that exact sort of "cascade failure" event. It will start in the credit markets because that is the only place that can set off such an event.

A Bear Market itself starts in the Stock Market, but a crash always initiates in the credit markets.

What will occur is that "someone" (perhaps a hedge fund) will need to liquidate the essence of their entire position due to some sort of event - perhaps the Yen Carry Trade will unwind on them in a bad way, or there will be a series of losses that result in margin calls they cannot meet without selling assets that they'd prefer to hold.

This forced liquidation will drive down the price of those assets, as it will be anything but an orderly event. Let's say, for example, that the Hedgie has a very large (2M share?) position in a given stock - let's use Countrywide Financial.

Ok; they are forced to dump the whole thing. This depresses the price radically, perhaps by $10 a share.

That, in turn sets off margin calls in other places, because the value of that stock will be marked to the market which has just fallen out.

The second, third and fourth margin calls will generate even more forced selling, which will in turn generate even more margin calls!

Now a simple stock is probably not the nexus. In all probability the trigger event will be something that is almost-wholly-contained in the credit markets - e.g. a swap-writer will be forced to cover losses, which will cause a mass-downgrading of bonds because of the losses. This in turn will force Pension funds to divest themselves of the bonds, because they are no longer investment grade (and thus can't be held.) THAT causes a mark-to-market of all the other people who hold similar or identical bonds, which, if you're leveraged too far, creates a margin call in your account! It reaches a fund that has enormous stock positions, and they are forced to sell them to meet the call. THAT is when it crosses the boundary and now the Margin Calls start in the stock market as well.

Once critical mass is reached the reaction proceeds through the system until equilibrium is reached. This can take quite a while - it is not a one day process - and in the process it decimates equity prices as the credit market locks up like a sphincter on overdrive. Since you can't borrow money in order to meet the margin call your only option is to sell the assets - at any price.

Now the obvious question is "are we staring at something like this?" I have no idea. But we have had a warning recently from China that they're concerned about the "irrational" rise in their markets and, presumably, the use of margin. We have had a warning from the NASD about margin use here. Yet the "visible" margin that the NASD can see is minuscule compared to that in Hedge Funds and Brokers in the credit markets - places where the NASD has basically zero visibility. It is estimated that $9 Trillion is floating around in the US Credit and Equity Markets in the form of leveraged debt.

What we do know is that this debt has been massively mis-priced. Credit is incredibly cheap - even for junk-rated debt. This is not a good thing. It has enabled lots of deals to get done, but it basically means that nobody expects that any of these debts will not be repaid.

Of course in the real world the more risky the venture, the more likely it fails.......

The bigger problem is that nobody really is sure how the consumer and those people who bought all these mortgage-backed bonds are connected to all of the rest of it. We know they are, but we don't know exactly how, or which buttons we can push - and which ones detonate the bomb.

What we do know is that credit is already starting to dry up. Mortgages are getting harder to originate, and costing more. Consumers are starting to slow down - they can't take money off their house any more, so now they're hitting the plastic - and when that runs out, then they're "done". There is evidence showing up by the day that this stress is building rapidly and that must lead to a drop - probably a precipitous one - in consumer spending.

If that event leads foreign investors to dump US-denominated debt instruments, you will see liquidity in the credit markets disappear almost immediately.

This sort of thing is what I am most concerned about. There are ways to get somewhat of a "hint" before it happens, but by definition when things "explode" you will get little if any real warning. One thing is certain - if you start to see it "go off", its time to get away from the blast zone!