Let’s touch just a little more on how this market may play out. The key thing to understand is that most actors in the market are there on a margin account. When they buy a security they do so with part their money and part (the larger part, usually) money borrowed from their broker. To protect the value of the money the broker loaned to their client, the broker insists that some money be kept in a margin account. The amount in the account is based on the price of the security bought. If it drops enough, the margin that is protecting the broker may become too low, in which case they issue a margin call "we need you to make up the difference". If you bought a share for $10, with $3 of your own money, the broker loaned you $7. However the share can be sold to make it up. So really, they’re safe. But what if the share drops to $6? Suddenly they aren’t safe, you owe them one dollar they can’t get. So they phone you up and say "deposit a buck." Except that you own 10,000 of the shares, so it’s $10,000 they want.*

To meet that, what do you do? Well, you might take money out of the bank. Or you might sell another security to meet it.

An Ohmstead break in a market is when the market drops so much that margin calls turn into a vicious circle. Stocks drop in price. Investors get margin calls. They sell securities. That causes the market to drop even more, meaning even more investors get margin calls. They sell securities. I’m sure you can see where this going…

So, what number will cause an Ohmstead break? We don’t know. But we’ll know if we hit it. And if it happens, there’s pretty much nothing that can be done to save the stock market from losing a couple thousand more points.

Where will it stop? Well, the bottom of bear markets tends to be around 7 time the price/earnings (p/e) ratio. Right now, very roughly, that’s about Dow 6,000.

When will this happen? Who knows? It may not even happen at all. But by the long term historical rule of thumb, that’s about where the Dow is heading.

(The effect of the Paulson plan on this? Minimal to nonexistent.)

*Note: vastly oversimplified, there are a number of different ways to calculate margin requirements and they can be changed. In fact, banks insisting on more margin/collateral is one of the exacerbating factors of this meltdown.

Ian Welsh

Ian Welsh

Ian Welsh was the Managing Editor of FireDogLake and the Agonist. His work has also appeared at Huffington Post, Alternet, and Truthout, as well as the now defunct Blogging of the President (BOPNews). In Canada his work has appeared in Pogge.ca and BlogsCanada. He is also a social media strategy consultant and currently lives in Toronto.

His homeblog is at http://www.ianwelsh.net/