Dis, In and De - Which 'flation will it be?

The recent pull back in the market - the recent decision by investors to take risk off the table - the recent decision by investors to re-enter the corporate bond world for returns, all are being propelled partially by a fear of sovereign debt crisis in Europe. And while that could spell major problems, it appears that the true fallout of the situation has been punted down the road thanks to the EuroZone backstopping Grecian and Spanish and Portugese economic problems with a $1 trillion fund/guarantee. In fact, this is quite similar to the US' TARP actions -- which as you may recall stabilized the markets and propelled the bullish run from March 2009 through March 2010.

Effectively, transferring the debt crises from private balance sheets to the public (government) balance sheet, allowed us to punt the problem down the road a few years and allow US companies to appear in much healthier shape (thus better profitability and deserving of higher market valuations). The problem -- the Eurozone isn't the world's #1 resort like the US nor is it as loyal and intertwined like the US states. The Eurozone doesn't have a central, authortative government with a commanding voice necessary in times of crises. Thus, the Euro TARP plans have less credibility and while the problems are delayed, the markets aren't always quite as convinced as they were in the US.

But ALSO partially responsible for the recent pullback is the economic effect and reality that is coming into focus. Markets had priced in stronger GDP and corporate rebounding. Partially the eurozone's fault for lowered economic outlooks (15% of the S&P earnings comes from Europe), but its also partially the result of a slew of US companies announcing this quarter more tempered expectations for the 2nd half of 2010.

With that come an adjustment in the stock market.

Is the economy going to grow in 2010 in the US? Yes. In the Eurozone? Probably, even if near neglibly. So should markets appreciate in value in the long run? Yes. Did they get ahead of themselves and now need a possibly significant pullback to accurately reflect the reality of the economic picture? I say yes and its appearing so.

The markets need to adjust to this new understanding that -- due to the original credit crises and now the sovereign debt crises -- a disinflationary, low inflation, or potentially deflationary environment will be the norm for a little while.

Recent report this week showed consumer inflation at a 1% level year over year. That shows growth but is so minimal that fears of skyrocketing inflation (in spite of all the government liquidity in the system) is not valid currently. Producer pricing/inflation also came out tame this week.

The result -- markets need to readjust for a more regulated financial system as well as more constrained economic growth due to higher taxes, a debt burdened US and Eurozone, a subdued Chinese economy and a constrained US consumer (reports this week showed 1 in 7 homes in now in default or foreclosure). The question becomes, what is the proper valuation/adjustment, 1100 in the S&P? 1025? 975?