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Opinion: Don’t be fooled — inflation is a big risk for stock market investors.

Don’t be fooled by the placid response to the highest inflation rate in over a decade. Inflation will remain elevated enough to shake up the stock market, possibly causing a selloff as much as 15%. You need to prepare now.

The reason: Persistently high inflation will move the 10-year Treasury yield to 2% and get the Federal Reserve to start tapering its stimulus by the end of the year. Both will rattle the stock market.

The government said June 10 that the cost of living surged in May and drove the pace of inflation to a 13-year high of 5%.

What should you do? Probably the opposite of what you are thinking. Before we get to that, here is a look at the two key events for stocks — in the bond market and at the Fed — between today and the end of the year.

Rising yields

Remember how the stock market freaked out earlier this year when the 10-year Treasury yield

moved up to around 1.7%? Well, expect a repeat. Only worse.

“We suspect that inflation in the U.S. will prove more persistent than investors currently appear to anticipate,” says Capital Economics economist Franziska Palmas, citing the tight labor market and wage growth. Her research group puts the 10-year yield at 2.25% by the end of this year, and 2.5% by the end of 2022.

That’ll be a big move from the current level of 1.5%. Stock investors tend to panic when interest rates rise a lot.

Fed tapering

Fed Chairman Jerome Powell has downplayed the need for tapering the central bank’s bond purchases to keep yields low. But half of the 12 members of the Federal Open Market Committee (FOMC) have recently said they’re ready to start talking about tapering. The FOMC is the Fed branch that sets monetary policy.

“It will be increasingly hard for Powell to claim the economy needs to make ‘substantial further progress’ toward achieving maximum employment before the Fed starts talking about talking about tapering,” says Ed Yardeni, author of Predicting the Markets and head of Yardeni Research. Powell has repeatedly said the Fed is awaiting “substantial further progress” in the economy before terminating its stimulus.

“Given the performance of the economy, it is reasonable to expect they will start to taper before end of year, and a few months later they will start to raise the federal funds rate,” predicts Yardeni.

He thinks the Fed will announce a decision to start tapering in its July meeting. Tapering refers to a reduction in bond purchases by the Fed. This tightens the money supply to put the brakes on growth. Once purchases go to zero, the Fed moves on to cutting rates.

As we know, tapering causes a “taper tantrum” in the stock market, meaning a sharp selloff in indices like the S&P 500
the Dow Jones Industrial Average

and Nasdaq

How to prepare

When considering how to position for the probable selloff caused by rising bond yields and Fed tightening, the key things to remember is why these things are happening in the first place, and what history tells us about how stocks behave.

The consensus view is that tapering and rising bond yields kill off economic growth and the bull market in stocks. But this isn’t actually true.

Yes, initially, tightening can make stocks fall — or churn sideways, at best. But then stocks shake it off and move higher as the bull market continues. This makes sense, because the tightening is happening for good reasons that help companies — strong economic growth. This pushes earnings a lot higher, which resets valuations lower — back down to levels investors feel comfortable with.

“Tapering is part and parcel of a recovery,” says Leuthold market strategist Jim Paulsen. “It is a response to successful policy and a rebound in the economy. It is a natural part of the bull market that allows the market to go higher. It’s a healthy development.”

Looking through all the market fireworks that may lie ahead, Paulsen thinks underlying economic growth will push S&P 500 earnings up to $220 by the end of the year. Assuming the S&P 500 is at current levels or a little bit lower, that would bring the index’s price-to-earnings (P/E) ratio down to 18-19 — which is near or below the average since 1990. “That sets up the next leg of the bull market,” he says.

Your five-point game plan

1. Do not go to “defensives”

When people see stock market turbulence, the knee-jerk reaction is to go for the “stability” of defensive names like utilities and consumer staples. But that would be a mistake. You want to go to defensives when the economy is slowing or contracting, not when it is strong. Another problem is that defensive names pay…

Read More: Opinion: Don’t be fooled — inflation is a big risk for stock market investors.

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