Vince Farrell
CNBC Contributor

It's hard to drain the swamp when you are up to your butt in alligators. We are seeing a margin call on hedge funds of unprecedented proportion. But then we have seen unprecedented growth in the number of hedge funds.

When Lehman failed the fear your counterparty on the other side of some of these esoteric trades like credit default swaps went from theoretical to real. The rush to unwind trades reached into every corner of the globe and into every asset class.

There was a quote in the Wall Street Journal yesterday from a single mother of two in Hungary who was worried about her mortgage since it was denominated in a foreign currency and the trade was moving away from her. What is a single mom doing in the currency game? The world borrowed cheap dollars and/or low interest yen and invested around the world. With everyone rushing to the door at the same time to unwind those trades the dollar and yen are being forced up as people have to repurchase the borrowed currency.

As oil has fallen due to a drop in demand, the long oil/short dollar trade has been broken. The long oil/short financial stocks has also failed. With a ton of borrowed money on top of the trades, hedge funds are forced to sell as debts are called and as clients want out. Mutual fund investors are heading for the exit as well so selling begets selling.

At some point the selling will be done and we will have to assess the debris that is left. The most pessimistic estimate I have seen for earnings next year (for the S&P 500 index) is $60. The consensus is still way, way above that. But let's use $60. With the S&P average now around 875 the implied price/earnings multiple is 14.5.

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If 2009 was to be the trough, or near the trough in economic activity, an average multiple on trough earnings is conservative. The uber-bears say the multiple should be much lower. But with a slowdown in activity sufficient to have earnings come in that low, inflation will be a non issue and multiples won't be low. The most likely way for a low multiple to be applied would be a threat of deflation.

It's hard to imagine a deflationary scenario with the massive flood of liquidity Central Banks are unleashing on the world.

We are trying to find a bottom. The intraday low in this cycle was 840 for the S&P. The 2001-2002 triple bottom low was around 775. At 775 the market would be down just over 50% from its October 2007 high and would be the worst bear market since World War II.

Hang on to the sides of the kayak. We are in the rapids.

But keep in mind the article from Barron's I mentioned a short while ago. A dollar invested in the market in February, 1966 grew to $16.58 by May, 2007. And during that time we had seven bear markets (declines of at least 20%) including -48% in 1973-74, -33% in 1987, and -49% in 2001-02. We need to try and look beyond the moment.  

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Vincent Farrell, Jr. is chief investment officer at Soleil Securities Group and a regular contributor to CNBC. 

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