Friday was a bad day in the stock market, and while some of the blame falls on the weak employment report, sinking dollar and high oil prices, here’s the real reason why the market tumbled:

Suppose you are the Secretary of the Treasury. A serious credit crisis has been going on for months, with locked-up credit markets, multibillion dollar write-offs at banks, busted hedge funds, bankruptcies of public mortgage companies and the whole nine yards. An inept Fed Chairman has been behind the curve the whole way in trying to stop the downward spiral. Now high-quality firms like Thornburg Mortgage, which leverage their equity to invest in AAA-rated debt of government-sponsored entities (GSEs), like Fannie Mae and Freddie Mac, are getting their loans called. They are forced to sell the AAA-rated paper to meet what is essentially a margin call, and even AAA-rated paper from these GSEs is infected by credit fears and losing value under the selling pressure.

What would you do? What would you say to calm the markets? Here’s what Treasury Secretary Hank Paulson effectively said on Friday: “I just want to remind everyone that the government does not really guarantee the debt of these GSEs, and rumors that we might guarantee them are absolutely not true.”

And down goes the market. Thanks, Hank. The S&P 500 not only failed to regain the 1326 level — finally breaking down on the weekly chart — it managed to close below the next support level down at 1295. The next possible area of support is 1270, only because that was the spike low on January 23. That level hasn’t really been tested, and if it breaks, the next stop is 1180.

Another thing that I really didn’t like about Friday’s market was that the VIX Fear & Greed Index did not show a spike of fear. Just before 3 p.m. Eastern Time, it was climbing nicely, but then it dropped back to a complacent 27.49 close. Markets bottom in an atmosphere of fear, not an atmosphere of complacency. The VIX should have closed well over 30, given the breakdown in the S&P 500. But instead, the slight signs of life in the last hour of trading immediately brought the VIX back down.

Considering the S&P’s actions on Friday coupled with the low close of the VIX, I think the whole 110 point down move from 1290 to 1180 on the S&P 500 could come in one day, equaling a drop in the Dow Jones Industrial Average of over 1,000 points. The drop from 1255, the spike low in the futures market on January 23, to 1180 could come in one or two hours.

Unlike Bernanke, Paulson is not inept, and neither of these guys is stupid. So there must have been some reason for Paulson to pull the rug out from under the credit markets at this point, other than his old employer, Goldman Sachs, being net short the affected stocks and bonds. But I have spent the weekend trying to answer Lenin’s question (“Who gains?”), and I can’t figure it out.

I suppose that it doesn’t matter, because all we care about is what comes next. Either the S&P will climb back over 1295 and head toward 1326 before collapsing, or it’s just going to keep dropping from here. Either way, the stage is set for a 1,000-point Bernanke/Paulson Crash in the Dow. I expect the VIX to be over 40 when we hit bottom.

Can we avoid it? Sure — that’s the other 50% probability. Remember that the market will always try to shake out every bull or bear, before setting off on a major trending move in the opposite direction. I was quite bullish last Wednesday because the S&P 500 was perfectly set up for a major rally to 1440 and beyond. So maybe I am the one getting shaken out this time, just before the delayed rally begins. But that’s not the way to bet until the market itself tells us that it wants to reverse and go up. I suspect that we won’t get that final test down and rally until after the Fed’s March 18 meeting, which would about coincide with my March 22 turn date. (March 22 is a Saturday and March 21 is a holiday, so the actual market turn or final retest should come on Thursday, March 20 or Monday, March 24.)

As I said Friday, if you are a long-term investor and can ride it through, you don’t have to do anything. After March 24, as worries about the credit crunch and a recession fade, I expect our stocks to lead the broad market in a strong move up into an April 2009 top.

But also as I said on Friday, if you want to ease the pain of watching a very sharp short-term decline, or even profit from a downturn, here’s what to do:

• Get off margin;
• Don’t buy any more stocks until you see the market clear the 1326 level;
• And unless you see a strong rally today, you should buy short-term protection and then remove the protection if the S&P 500 rallies decisively above 1326 and seems likely to close there.

Protection could include short selling the S&P Depository Receipts (SPY), buying the S&P Depository Receipts April 129 puts (SPYPY) that I discussed in Friday’s Flash Alert, or for retirement funds, buying the ProServe UltraShort S&P 500 ProShares (SDS), an exchange-traded fund that moves up at roughly twice the rate the S&P moves down.

I am going to add SDS as a recommendation in the New World Investor portfolio, and I will send you another Flash Alert when it is safe to close the position. And don’t miss Thursday’s Radar Report, where you’ll learn how playing Monopoly during snowy winters on a Maryland dairy farm as a 10-year-old prepared me for the Bernanke/Paulson regime.