Time to Build Your Defenses

 | Nov 18, 2011 | 7:57 AM EST  | Comments
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While "correction" is the diplomatic term for market decline, it also connotes the idea that an excess is removed from the market, leaving it healthier. The open question is whether a rally can also be a correction, in that sense. I happened to glance at the monthly sequence of returns for the S&P 500 for this year, and the huge October rally stands apart as an outlier. Rather than signaling the start of a new rally, I am starting to believe October was a rapid "correction" -- and we are now resuming the pattern that started last spring. Inquiring minds want to know, so here is a quick-reference table.

My thesis from late August was that there would be an upward "drift" with a lot of violent swings both ways, netting out to a small positive return. The thought was that the U.S. economy would be better than expected, while Europe would be worse. So far, the thesis has been kind of wrong.

The U.S. economy has been better, and Europe is as bad as I thought it would be, and the violent swings are still present. But the drift has been mostly downward, with October having delivered one swift rise. Clearly Europe is more important than the domestic economy now -- and this is probably the correct reaction. When (not if) Europe implodes, the European banking system will be gutted, and many U.S. banks will see written credit default swap (CDS) positions create very large losses.

The run on Europe is already happening -- sovereign yields on PIIGS nations (Portugal, Italy, Ireland, Greece and Spain) are only being kept below 7% because the European Central Bank is buying their debt, and even that effort is failing. Trade in Europe is going to grind to a halt, as Germany will have no one to export to, and the Club Meds will have no money to buy anything. This outcome is inevitable, and necessary to fix the imbalances that built over the decades. It will be painful, however. I foresee a global recession in the first half of 2012.

My position is simple: Expect inflation from the huge monetization being done by the Fed and, soon, by the ECB. As for what you should own, focus on gold and defensive companies that sell staples and can price as inflation accelerates. Gold has the added benefit of being in its strongest seasonal period, so it should do well through the holidays.

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