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Let’s try to break this all down in less than 2 minutes:

We’re in a balance sheet recession following a massive debt bubble.  That’s made the US economy abnormally weak.  Like a sick patient, this makes us highly susceptible to any exogenous risks.  Currently, the biggest exogenous risks are Europe and China although Congress and the Fed appear to be trying their best to repeat the mistakes of 1937 (though not quite yet).

The Europeans keep kicking the can down the road.  They either need to let the periphery nations default and defect (which would have disastrous near-term impacts) or they need to move towards greater unity.  There is simply no other choice.  Right now there clearly isn’t the political will for a move towards full unity although I think they’ll realize that they must move in that direction.  All the while, civilian unrest increases the risk that the politicians are running out of time and can’t afford to kick the can until they resolve the issue.

The bigger fear is in China currently.  While the Euro crunch is well known by market participants, permanent strong Chinese growth has also come to be expected.  China has long been the lone strong leg in the recovery.  In January 2009 I said China led us into recession and that they would lead us out:

“The U.S. might have played an instrumental role in causing many of the issues at hand, but the S&P 500 revenues are now 50% abroad and trust me – the domestic 50% weren’t the ones driving the Dow recovery from 2003-2007.  China led us into this recession and it’s likely that China will lead us out.  And after a 70%+ decline, China’s not looking like a bad long-term bet to me….”

That story hasn’t changed much.  I think FedEx’s earnings nicely summarized the two speed recovery in the developed world and the Asian economies.  A major slow-down in China would severely depress profits and at the end of the day, that’s what the markets are most concerned about.

Personally, I don’t think we need to panic just yet.  The China slow-down is far from overshooting to the downside and the Europeans simply can’t afford to let the situation spiral out of control.  There is too much to lose.   The European politicians have invested too much time and money into this Euro project to allow it to just crumble now.  China is a much bigger question mark.  Their economy is a black box of central planning and irrational government intervention.  One thing is certain – inflation almost always resolves itself in the form of recession.

The question now is how deep will the Chinese economy slide and how much will it hurt US corporations?   I think buy and hold investors are silly to wait around and find out.  In the meantime, I think the markets look more attractive than they did in May when I said we should all be hedging risk and/or selling.

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