The Fed FINALLY did something meaningful, cutting the Fed funds rate three-quarters of a point this morning. I often say that the market tries to fool the most people that it can as much of the time as possible, and it may be about to fool me. But the bottom line is this:

If after this dramatic Fed move we see one or two more days of high intraday volatility without much change in closing prices, and if the S&P 500 does not bounce sharply back to the 1326 support level and then move easily through it, we will have a market pattern from which crashes occur.

I am not trying to be an alarmist — I spent much of the long weekend reviewing the data, the news and the reaction to the news. After a sharp, volatile decline like the one we’ve had since December 26, it is healthy to see the market consolidate by bouncing up, coming back down to test the low, bouncing again and then testing again — that’s OK. But here’s where it gets dangerous: When the market consolidates by posting a few days with wide intraday swings but little net change. We do not always get a market crash following this pattern, and every crash is not preceded by this pattern, but there’s enough smoke to start thinking about yelling: “Fire!”

After a big decline like the one we’ve been seeing, bargain hunters should be stepping in and daytraders should be looking for opportunities to squeeze the short sellers. That has not been happening, though, and last Friday we were left sitting at a crucial weekly and monthly support level around 1326. A major decline this morning could be the start of a crash, but the performance of the British market suggests that our market is more likely to rally back up to 1326, either celebrating the news that the Fed has finally taken effective action, or more ominously just on a test of the breakdown level. But closing near 1326 would just be another day of high intraday volatility with little change in closing prices, and that is the pre-crash pattern. Basically, if the S&P 500 can’t recapture 1326 and go up from there right now, we could be going down much further than I’ve been thinking.

The problem is obvious. Last Thursday, stocks held up very well until Chairman Bernanke began speaking, and then they promptly tanked. On Friday President Bush put forth his $145 billion tax rebate proposal, and the market promptly tanked. The market is saying that the Fed and the Administration just don’t get it, and what they are doing is too little, too late.

When he was in private life, Ben Bernanke was a vigorous advocate of the Fed moving quickly and decisively at the first hints of real trouble, whether to tighten or loosen, because he said that it took much more firepower to turn things around if the Fed got behind the curve. It must be a lot easier to talk the talk than walk the walk, because he is so far behind the curve, he’s been lapped. The Fed supposedly keys off the two-year Treasury note, where yields have sunk well under 2.50%. Yet Bernanke and his gradualist one-quarter-point rate cuts had the Fed funds rate still up at 4.25% before this morning’s cut. That’s very restrictive. When he opened his mouth on Thursday, the market only wanted to hear one thing: “We are cutting the Fed funds rate three-quarters of a point immediately, without waiting for the January 30 to 31 meeting.” He didn’t say that, and the market tanked. This morning, he said it — but it may be too late. Even the new 3.50% funds rate is restrictive, as it is well over the yield on two-year Treasuries.

President Bush’s Friday plan was equally demoralizing for a series of reasons. First, everyone believes that he has little interest in economics and doesn’t really understand what is going on. Second, this was a drop-in-the-bucket plan, not even targeted at the real problem. Third, in an election year, the Democrats are not going to give the President a win. Instead, they are going to propose a much larger program and dare him to veto it, so they can pillory the Republicans at the polls. If he doesn’t veto it, the deficit skyrockets on his watch. If he does, President Hillary will blame every bad economic event for the next two years on Republicans.

After thinking about all this during the weekend, I came up with another reason to be worried. It requires assuming that Chairman Bernanke is not stupid and incompetent, but stay with me here. Admittedly, one reason to believe that the Fed got so far behind is that Bernanke is clueless. Yet the guy academic-smart, has served on the Fed before and was a frequent critic in great detail about how the Fed should operate.

Now that he’s the Chairman, he isn’t doing anything that he advocated in private life. Why? My new worry is that he has some reason to do this, and he is deliberately keeping the Fed funds rate higher than the two-year Treasury note. He is flooding the economy with cash (the quantity of money) but keeping the price restrictively high (the cost of money, or the interest rate). Greenspan slashed interest rates so banks could borrow from the Fed, buy Treasury notes and use the profits to rebuild their balance sheets. Remember that the Federal Reserve System is owned by its member banks, not by the taxpayers, and the Fed will always step in to help or save the banks. So why hasn’t Bernanke played the Greenspan game to bring Citigroup, Washington Mutual and others back from the brink?

My thought is that maybe he wants to change the rules before the overall situation gets so out of hand that there really is a devastating depression. I’ve been thinking the Big One is coming as early as 2010, and sometime before 2015. There is so much debt in the system to be liquidated that I think the big depression is inevitable. But it’s also clear that Bernanke could easily keep the economy glued together for another cycle — there’s no reason that he has to take the big downturn right now.

But what if that is his agenda? It would explain everything he’s done — his reluctant action bordering on inaction, his late-to-the-party Fed funds rate cut before the opening today, and even his no-comfort choices of words and phrases in speeches like Thursday’s. Maybe he’s decided or been told to take a big hit now, instead of a knockout punch in three to five years. And maybe the market has figured that out. According to the very accurate economic forecasters at the Economic Cycle Research Institute, there is a real, albeit brief, opportunity for dramatic policy action to head off a downward spiral. Here’s a three-minute video of an Economic Cycle Research Institute (ECRI) analyst explaining their position, and how there are only a few weeks left until it’s too late to avert a recession. The Fed needs to drop rates by a huge amount, right now. Bernanke knows it. So why did he wait so long to take the first big step? How quickly will he cut another 75 basis points to be sure the economy does not spiral down?

I still think the most likely scenario is that he does not have a hidden agenda, and that he is simply stupid and incompetent. If that’s right, the most likely path from here is a bounce back to and then above 1326 that builds on all the negative sentiment, gets fed by this aggressive rate cut and the prospect of another one at the end of the month (three-quarters of a point, please), gets teased along by headlines about a possible tax rebate coming, and winds up tracing the usual fourth year of the Presidential cycle: High-level churning without much overall progress for the year. In that environment, our stocks will do fine — much better than their current prices would suggest. Stocks overall are very depressed on the I/B/E/S valuation model, and bear markets rarely start from low valuation levels.

But we need to watch the market action very closely over the next few days, because this truly is a time that the market will tell us what is going to happen. The market is very good at predicting economic outcomes, and if we get the bounce that I am looking for, there will be no recession. In fact, there will be one of the biggest snap-back rallies in history.

But if the market continues to believe that the Fed and the Administration are going to do too little, too late, look out below.

The Asian markets were hammered on Monday and Tuesday, with Tokyo down 8.8%, Hong Kong’s Hang Seng index down 13.7%, and China’s Shanghai Composite index plunging 11.9%. India’s market fell 7.4% on Monday and trading was halted for an hour on Tuesday when the Sensex index plummeted 9.8% within minutes of the opening. It came back to close down 5.0% for a two-day loss of 12.0%.

Since the start of the year, Japan’s benchmark index is down nearly 18% and Hong Kong’s Hang Seng index is down more than 22%, mostly due to worries over the U.S. economy. While some folks persist in believing that increased trade within Asia has made the region less dependent on the course of the U.S. economy, I still think that Asia will suffer substantially from a U.S. recession. I’ll be watching the Asian markets to confirm that whatever we see in the U.S. market is for real.

The European markets were down sharply overnight in their worst sell-off since the September 11 terrorist attacks, but recovered much of their losses after the Fed funds rate cut announcement. In the U.S., just before the Fed’s announcement, the Dow Jones Industrial Average futures were down 523 points, or 4.3%, and the S&P 500 futures were down 64.4 points, or 4.8%.

The Bottom Line: This is a risky situation, even though we probably will avoid a crash thanks to the three-quarter-point rate cut. Here’s what to do:

1. After this S&P 500 drop at the opening if there’s an intraday rally back to test the 1326 level, you should get off margin. The market may pass the test and go above 1326, in which case you can get back on margin as soon as we see a successful test back down to that level, which would again act as support.

If you are really worried or on margin, you can try the short-term put or ultra-short exchange-traded fund strategies described below without waiting for a rally up to test the 1326 breakdown level, but watch out for a quick, cathartic flush down that quickly reverses into a slingshot higher. That would hand you big losses on your puts or exchange-traded fund position unless you are mighty nimble and get out as the market is reversing.

2. If the S&P 500 doesn’t rally back to 1326 in the next day or two, expect a crash. You can either buy a short-term protective put or, for retirement accounts, an exchange-traded fund that goes up when the market goes down. I would buy puts on the S&P Depository Receipts (SPY). The February contract expires on February 15, which is long enough to let this little drama play out. The simplest idea is to buy puts that are at or just out of the money. Each put contract costs 100 times the quote, and protects about 50 times the strike price. So a 132 contract, which closed at $3.60 on Friday, would cost $360 and protect about $6,600 of portfolio value. That’s a half a percentage point off your annual return for a few weeks of protection — it isn’t cheap.

If the SPY fell $1 to 131, a portfolio of 100 shares of the SPY would fall from $13,200 to $13,100 in value. The 132 contract would go up in value to about what a one-strike-higher contract cost on Friday. The 133 contract closed Friday at $4.05. So the option contract value might go from $360 to $405, a gain of $45, while the portfolio value fell by $100. If you divide the value of your portfolio by $6,600, you’ll know how many contracts that you have to buy for something near full protection.

3. If we see another day or two of high volatility with little net change on the day, don’t be surprised by a crash. You can either buy a short-term protective put as above or, for retirement accounts, an exchange-traded fund that goes up when the market goes down. The UltraShort S&P 500 ProShares (SDS) works, or you can pick another one HERE. There are options on the SDS, but they are so illiquid that I would not trade them.

Right now, I would treat any flush down from current levels as a major buying opportunity, and plan in advance what you would like to add to your portfolio at give-away prices. Companies that are sensitive to the economy have been beaten up the worst, and their stocks should bounce first when the real rally comes. Here’s a good shopping list:

Akamai Technologies (AKAM)

Alvarion (ALVR)

American Science & Engineering (ASEI)

eResearch (ERES)

Harmonic (HLIT)

Intel January 2009 $22.50 LEAP calls (VNLAX)

Motorola January 2009 $17.50 LEAP calls (VMAAW)

QuickLogic (QUIK)

SiRF Technology Holdings (SIRF)

TowerStream (TWER)

US Geothermal (UGTH)

I will send a Flash Alert again if it looks like you should suspend all stock buying for a while, but that’s not likely to happen. I doubt that we will sell anything at this point, yet we have to be ready for whatever comes. There probably will be frequent Flash Alerts during the next couple of weeks.